Mark your calendars:  Monday, July 28, 2008 the Conglomerate Junior Scholars Workshop begins!  As a junior scholar, I have had many conversations about the difficulties of new professors getting good feedback, mentoring, and workshop opportunities.  As always, we try to be part of the solution, not the problem.  To that end, we continue our four-year tradition of a summer workshop by bringing five papers from five pre-tenured authors.  Although every junior scholar (and junior associate, etc.) claims to want feedback, these olks are actually putting their work on the line for real feedback, which says a lot about them as current and future scholars.

In case you are new to the Glom, the workshop will run like this: over the next three weeks from July 28 to August 11, we will showcase one paper every few days.  Three or more reviewers will have already written comments to this paper, and I will post those comments the morning of the chosen day.  At that point, comments will be open and we hope that our interested and engaged readers will take the ball from there.  We treat this workshop just like an academic conference.  You are encouraged to stand up and ask a question, but you have to state your name (i.e., no anonymous comments).  And, like a conference, if you have a question or an insight that you would rather offer after the talk at "the podium," feel free to email the author directly.

The participants in the Fourth Annual Conglomerate Junior Scholars Workshop are:

● July 28: Brian Broughman, The Role of Independent Directors in VC-Backed Firms

● July 30: Ethan J. Leib, Friends as Fiduciaries

● August 4: Heather Field, Checking in on Check-the-Box

● August 6: James Park, Assessing Materiality of Financial Misstatements

● August 11: Minor Myers, The Decisions of Corporate Special Litigation Committees:  An Empirical Investigation

Our gracious commentators include (in no particular order): Tom Ulen, Bill Carney, Larry Ribstein, Brett McDonnell, Doug Moll, Bob Lawless, Barbara Black, Steven Dean, Gregg Polsky, Leandra Lederman, Joan Heminway, Adam Pritchard, Larry Cunningham and former workshop participants Darian Ibrahim, David Gamage, Eric Goldman, Paul Rose, Bill Henderson and Dave Hoffman. The workshop does not run without these wonderful people, and we are very grateful to them.

Next week, I will post links to all five papers. See you then!

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Just a reminder -- the Call for Papers for the Fourth Annual Conglomerate Junior Scholars Workshop is open until June 30, 2008.  The original CFP is here. 

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Back by popular demand: the Conglomerate Junior Scholars Workshop for untenured law professors or candidates entering the law teaching market this fall. The submission deadline for completed papers is June 30, 2008.

Conglomerate has now hosted this workshop for the past three summers, and we have come to believe that the workshop provides a great service of matching junior authors with more senior experts in their field and also with other readers inside and outside of the academy.

The Fourth Annual Conglomerate Junior Scholars Workshop will be live online around July 28, 2008, with allowance for the schedules of our commentators. We will host one or two papers each week, with the paper and solicited comments posted the morning the paper is showcased. We anticipate hosting no more than five papers to ensure reader participation and attention for the duration of the workshop. Because of this desire to narrow the field somewhat, not every paper will be selected for public posting on the workshop. Criteria for selection will work to create a roster of papers that

* add to the existing literature on that topic

* are at a point of substantial completeness

* from junior academics

* at a wide array of academic institutions

* on topics that fit closely with the interests of the authors and readers of Conglomerate.

Although the umbrella of corporate law covers many topics, we will choose topics that allow us to easily solicit expert commentary and that attract reader comments. We are not deluded enough to believe that being chosen for the workshop has value in and of itself; the value lies in attracting commentary and reader suggestions as part of the workshop. Thus, we see no value in choosing an otherwise excellent and intriguing paper if we cannot use our networks to line up expert commentary. In addition, we feel that the greatest value of the workshop lies in giving feedback and exposure to junior law professors. Therefore, papers chosen will be authored by those junior academics in full-time academic positions, whether visiting assistant professors, fellows, or tenure-track professors. Papers from practitioners will only be chosen in the rare circumstance in which the author is actively pursuing an academic appointment in the upcoming hiring season.

Call for Papers:

If you are finishing up a scholarly article this summer on a topic that may be interesting to Conglomerate’s readers – such as corporate law, securities, contracts, business tax, finance, antitrust or law and economics – we would like to invite you to submit a completed draft to be considered for the workshop. During the workshop, we will link to your paper and provide a forum for you to receive feedback on your paper before you publish it or present it at a conference, workshop or job talk. We may also consider articles accepted for publication if the paper has not reached the final editing stage. We know that many new faculty members do not have the opportunity to present papers at national conferences and find it challenging to get others in their field to read their work. Hopefully, this workshop will facilitate that process.

The mechanics of the workshop are the same as in past years; we will post SSRN links to each paper in the workshop prior to the beginning week. On the specified day, a post will go up for the paper of the day, with an abstract of your paper and some initial comments by invited guest commentator(s). Afterward, you can respond in the comments to the commentator, and readers will post additional comments, creating a cyber discussion of your paper. If you read the blog or know us personally, you know that we strive to be the "if you can’t say something nice" people, but the workshop will not be helpful unless commentators are honest critics. So, we will be supportive of your work, but give constructive criticism as necessary. We will also prohibit anonymous comments in an effort to make sure only serious commenters participate. However, you are advised that your paper will be accessible to the public on SSRN and via links on our blog and that we anticipate having relatively high reader traffic during the workshop.

If any of this sounds good to you, please email me (achurt@illinois.edu) with your information, an abstract of your article, and your completed draft by June 30, 2008. No submission will be accepted on the basis of an abstract without a draft. Likewise, contact me if you have any questions. And most importantly, please pass this invitation to others that may be interested.

Call for Commentators

: If you are a reader and would like to be a commentator for one of the papers presented, please let me know that as well. If you were a presenter in a previous year's workshop, then you may feel moved to repay the benefits you received by stepping into that role this year. And, just because you don't call me, that doesn't mean I won't be calling you!

I am also posting the roster from previous Conglomerate Junior Scholars Workshops:

David Adam Friedman, Reinventing Consumer Protection

Miriam Baer, Insuring Corporate Crime

Trey Drury, What's the Cost of a Free Pass? A Call for the Re-assessment of Statutes that Allow for the Elimination of Personal Liability for Directors

Alexander "Sasha" Volokh, Privatization and the Law and Economics of Political Advocacy

Darian Ibrahim (Arizona), The (Not So) Puzzling Behavior of Angel Investors

Paul Rose, The Corporate Governance Industry

D.A. Jeremy Telman, The Business Judgment Rule, Disclosure, and Executive Compensation

Susan Morse, The How and Why of the New Public Corporate Tax Compliance Norm

Adam J. Levitin, Inequitable Subordination? Enron, the Subordination of Good Faith Transferees in Bankruptcy, and the Need for General Commercial Negotiability

Eric Goldman, A Coasean Analysis of Marketing

William Birdthistle, Compensating Power: An Analysis of Rents and Rewards in the Mutual Fund Industry

Matthew Bodie, AOL Time Warner and the False God of Shareholder Primacy

Brian Galle, A Republic of the Mind: Cognitive Biases, Fiscal Federalism, and the Tax Code

David Gamage & Allon Kedem, Resolving the Paradox of the Consideration Doctrine

Mike Guttentag, Accuracy Enhancement, Agency Costs, and Disclosure Regulation

Bill Henderson, Effect of Single-Tier v. Two-Tier Partnership Tracks at AmLaw 200 Law Firms: Theory and Evidence

Ruth Mason, Prospects for a Multilateral Treaty Between the United States and the European Union

David Reiss, Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market and How They Can Be Stopped

Michael Woronoff & Jonathan Rosen, Understanding Anti-Dilution Provisions in Convertible Securities

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We have finished up the five papers in the Third Annual Conglomerate Junior Scholars Workshop, and I would like to take this post to thank all of our participants.  Thank you to all those who submitted articles and especially to the authors of the five papers we spotlighted:  Miriam Baer, Trey Drury, David Friedman, Alexander "Sasha" Volokh, and Darian Ibrahim.

Another very special thank you goes to our commentators, who generously give of their time and their spirit for very little in return:  Sean Griffith, Kim Krawiec, Mike Guttentag, Joan Heminway, Lisa Fairfax, Matt Bodie, Larry Garvin, Bob Lawless, Ronald Mann, Adam Levitin, Larry Ribstein, Barbara Black, George Dent, David Hoffman, Paul Rubin, Tom Ulen and Brian Galle.  Without these commentators, the workshop would not exist.  Gracias!

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Welcome back to the Conglomerate Junior Scholars Workshop.  Today's paper is The (Not So) Puzzling Behavior of Angel Investors by Darian Ibrahim.  Darian is an Associate Professor of Law at the University of Arizona James E. Rogers College of Law and teaches and writes in the fields of Business Associations, Law & Entrepreneurship and Contracts.  Today's expert commentary will be provided by Larry Ribstein, Barbara Black, George Dent and David Hoffman.

We invite readers to comment on the paper (and the comments) in the comments section of this post.  In the interest of running this workshop like a physical world conference, no anonymous commenters, please.

The abstract for the paper is here:

Angel investors fund start-ups in their earliest stages, which creates a contracting environment rife with uncertainty, information asymmetry, and agency costs in the form of potential opportunism by entrepreneurs. Venture capitalists also encounter these problems in slightly later-stage funding, and use a combination of staged financing, preferred stock, board seats, negative covenants, and specific exit rights to respond to them. Curiously, however, traditional angel investment contracts employ none of these measures, which is a marked departure from what financial contracting theory would predict. This article explains this (not so) puzzling behavior on the part of angel investors, and also explains why some angels are moving toward venture capital-like organization and adopting venture capital-like contracts in the process.

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Darian Ibrahim’s paper is a very useful discussion of the generally overlooked topic of "angel" investors.

These investors fill a gap in the venture capital world. Traditional venture capitalists fund startup firms until they are ready for the next stage – usually a public offering but increasingly to another private equity firm. But traditional venture capital involves costly contracting and monitoring, and therefore demands some scale. What do smaller entrepreneurs do before the VC firm arrives but after they’ve maxed out their credit cards?

They look for angels, of course.

As Darian explains, angels differ from standard-model venture capitalists in that they don’t use the usual, and costly, protective contracting mechanisms such as preferred stock, board monitoring, covenants. The main puzzle is why the angels don’t just leave the entrepreneurs with their credit cards. Darian has found, by my count, five explanations. I found these explanations useful and credible but not completely satisfying for the reasons discussed below.

First, angels are individuals, and therefore don’t have to face their investors like other VCs. But assuming the angels, who are businesspeople themselves, aren’t simply giving away their money (more on that below) they would surely need some assurances, wouldn’t they? The main difference between the contexts is the absence of agency costs on the funding side when the angel uses her own money. This necessarily introduces some rigidity in the relationship between the VC and the entrepreneur – part of the Gilson’s "braiding" of the two relationships. But it would seem that the agency costs between the investor and the entrepreneur would remain and demand some constraints.

Second, Darian talks about trust between the angel and the entrepreneur. Perhaps some of this comes from the fact that the angel funds local entrepreneurs. Reduced information costs mean reduced risk, other things equal, and therefore lower costs of trust. But Silicon Valley and its imitators similarly function as information-cost-reducers in the standard VC context. Does the trust come from family and friendship relationships? Probably not exclusively. Anyway, there’s the fundamental rule of MCE (money changes everything).

Third, the smaller scale makes it harder to use conventional VC-type mechanisms. To be sure, custom-designing constraints is costly. But are there off-the-rack contracts that might be used? More likely, as Darian says, the angel can’t use costly governance that a VC would later have to dismantle. And monitoring may be costlier per dollar invested, though it doesn’t seem the angels scrimp on monitoring – only on formal contracts. In any event, this factor would seem to restate the puzzle: why are angels willing to invest even if they can’t cost-effectively constrain the entrepreneur?

Fourth, perhaps the angels rely on self-enforcement, particularly including reputational mechanisms. But it would seem that there’s no more repeat play at work here on the entrepreneur’s side than in standard VC investing. Perhaps, as Darian says, the entrepreneurs are disciplined by the fact that they have to look good for the second-stage VC. But it’s not clear why this enforcement would be higher-powered than the VC entrepreneur’s incentive to look good to the investment banker and the public markets.

Fifth, and perhaps most persuasive, Darian discusses the angel’s private benefits, specifically the satisfaction they get from altruistically helping start-up entrepreneurs. In other words, maybe these really are angels! Darian refers to this as for-profit philanthropy. But that’s an oxymoron. Angel investing is qualitatively different from the sort of real philanthropy that AIO’s (see below) use, like endowing universities or funding soup kitchens. Angels want the entrepreneurs to be successful businesspeople, and that means earning money. Perhaps the altruism comes specifically in the form of a time contribution. The entrepreneurs could not pay market value for the time and expertise the angels devote to their investments. And time and expertise are the critical contributions that the angel makes.

Darian makes an additional and important contribution in his discussion of the development of angel investment organizations, which start to look a bit like venture capitalists, or at least like a gap-filler between angels and VCs. The key is that AIOs use the formal mechanisms that standard-issue angels eschew.

This is an important part of the discussion because it suggests the addition of a margin on which angel investing works, which enriches our understanding of the nature of angel investing. But in order to understand this better I’d like to know more? Are AIOs the next evolutionary stage of angel investing? Or do they handle a different set of firms? If so, what’s the difference between an angel-backed firm and an AIO-backed firm?

I’d also like to know more about the organizational structure of AIOs? Are they lps, like VC funds? Or non-profit corporations? (Limited partnerships can’t be non-profits). Does this structure influence how they operate, compared to standard VC firms?

I guess the value of this project is best demonstrated by the fact that I do want to know more. Darian has found an interesting, but under-theorized and under-explored niche, and has aptly suggested where future research in this area should go.

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First, I want to thank Christine Hurt for extending me an invitation to participate in the Conglomerate Workshop for Junior Scholars. I greatly enjoyed the opportunity to read and comment on Darian M. Ibrahim’s paper. I learned a great deal about angel investors and look forward to learning more as I read others’ comments.

Before there is venture capital, entrepreneurs need angel investors -- wealthy individuals who personally finance high-risk ventures that present both high-growth potential and great risk of loss. In this very interesting and informative paper, Professor Ibrahim provides illumination into the secretive world of angel investing. Angel investors act as the "conveyor belt," providing the funding as the start-up moves from the initial entrepreneurial stage to the point where venture capitalists are willing to invest and, in turn, move the venture toward an IPO or private sale. Professor Ibrahim sets up two distinct prototypes – the angel investor, who made his money running a business and is comfortable with his own ability to screen, monitor and control his investments, on the one hand – and the venture capitalist, who frequently does not come from an entrepreneurial background, invests other people’s money, and relies on corporate financing techniques to manage the risks.

In this way, Professor Ibrahim sets up his first puzzle. The conventional wisdom is that no one gives anyone a blank check; if you’re turning over a large sum of money, you want to maintain some control over it or at least protect yourself from opportunistic behavior. This played out in earlier days in the cases and literature involving limited partnership interests and minority shareholders in close corporations. Yet, Professor Ibrahim asserts, angel investors do not avail themselves of the kinds of protective measures that venture capitalists routinely employ. What accounts for this behavior? Professor Ibrahim first presents a solution to that puzzle and then presents us with another one – if it makes sense that angel investors do not bargain for protective measures, then why are we now seeing angel investors that are, in fact, acting more like venture capitalists? Professor Ibrahim explains this by describing how the formerly distinct categories of angel investor and venture capitalist have evolved into a third, hybrid category – the angel investment organization (AIO).

A great strength of this paper is its specific focus on the nature and the role of the angel investor. (A quick search on SSRN and Westlaw for law review articles with "angel investor" in the title turned up very little that was relevant on this topic.) Professor Ibrahim illustrates the distinctions between an angel investor and a venture capitalist, to make us recognize that an angel investor is not simply a first-stage venture capitalist, but a distinct prototype.

To frame it as a question familiar to securities lawyers, is the angel investor a "sophisticated investor"? The answer is certainly yes, based on the individual’s wealth and track record as a successful business person. On the other hand, the angel investor is

arguably behaving in an unsophisticated manner – he is (over?) confident of his own ability to select and monitor his investment, he does not bargain for contractual protections, and in many instances he does not diversify his portfolio. Professor Ibrahim describes some of the factors that could contribute to irrational behavior – the angel investor’s emotional attachment to the business venture, an altruistic desire to give back, the importance of trust. There may be others as well. How many investments by angel investors are motivated, at least in part, by family and friendship considerations, the excitement of being the first to invest in a new technology? What is the likelihood that contractual protections are passed up because of a disdain for lawyers? Professor Ibrahim allows for these non-financial considerations, but principally argues that angel investors’ foregoing protective devices is rational. They do not bargain for protective measures, because they understand their place in entrepreneurial finance and the need later on for venture capital. "Although venture capitalists recognize the importance of angels in entrepreneurial finance, they are hesitant to invest in start-ups where an aggressive angel’s preferences must be ‘unwound’ for venture capitalists to receive their standard preferences….The rational angel recognizes that she is the first, but not the last, source of outside investment and acts accordingly." Perhaps this is the case, but I am not sure if this very rational explanation is sufficient to account for the restraint to resist the very human tendency to demand what the reasonable investor could obtain. Angel investors may be yet another example of how reasonable or even sophisticated investors can act in non-rational ways, although, in this case, the non-rational behavior achieves a result that is logically defensible.

I appreciate the limited information available on angel investors and the difficulties in studying them, but I am left with a desire for more information to answer this conundrum. So the strength of this paper exposes a weakness. Professor Ibrahm provides a plausible explanation for angel investors’ behavior, but more empirical data would help to resolve satisfactorily the puzzle. In the absence of empirical data, more anecdotal evidence could shed some light on these questions. Do we know why, for example, twelve angel investors made the decision to fund Amazon.com, or why Andy Bechtolsheim invested in Google? There may be some great insights in these anecdotes.

Professor Ibrahim sees the rise of AIOs as the answer to the second puzzle – if angel investors behaved rationally in not demanding more protections, then why are they abandoning this model? I found the answer to the second puzzle less successful than the first. In part, this is because Professor Ibrahim was so persuasive that angel investors were a different kind of animal that it was deflating to find that they may have evolved into just another subspecies of venture capitalist. More fundamentally, the key question, as he identifies it, is what to make of the shift toward venture capital-like contracts in AIO investments? Professor Ibrahim has sketched out some plausible explanations for this development to demonstrate that it is not inconsistent with the answer to the first puzzle, but I think they require amplification to counteract the argument that the rise of AIOs is, as he puts it, "an overdue corrective for traditional angel naivety." He does not fully account for the inconsistency – if angel investors do not bargain for protective measures because they recognize the importance of later venture capital, why is not the same restraint present in the case of AIOs. His explanation – that venture capitalists may accept aggressive contract terms from AIOs because they view them as the equivalent of early stage venture capitalists – is incomplete, given the importance of the rational explanation for non-aggressive provisions in his argument in the first part of the paper. I recognize that here again Professor Ibrahim is confronted with a lack of empirical data to answer sufficiently the questions presented by the increasing popularity and visibility of AIOs. Professor Ibrahim’s conclusion may be that AIOs, despite their name, are really variations on the theme of venture capitalist and not really angel investors, in which case the link between the two puzzles becomes somewhat attenuated.

I have two smaller points that may simply reveal my ignorance of this field. First, the assumption throughout is that angel investors and venture capitalists are investing in corporations (references to common vs. preferred stock, board representation). Are LLCs not used in these start-up situations? Second, there are two references to the common complaint by venture capitalists that angel investors overvalue the enterprise. I would have liked a fuller explanation of why this is the case and how venture capitalists deal with it.

Congratulations on a job well-done!

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Darian Ibrahim’s paper, The (Not So) Puzzling Behavior of Angel Investors, is well-informed, thoughtful, well written, and extremely useful. I have several comments on it, but they are all minor, friendly amendments.

It’s an old saw that a minority equity investment in a closely held business is worthless. (See, e.g. Donahue v. Rodd Electrotype.) Venture capitalists make such investments valuable by a complex, ingenious package of protections, including staged financing, senior securities, board representation, vetos and exit rights. However, angel (or seed) investors often finance even riskier start-up companies without most or any of these protections. Ibrahim seeks to explain this seemingly reckless behavior.

Bravely (see infra) Ibrahim eschews any neat model. He posits that several factors influence angel investors’ conduct, including reliance on trust (based on personal contact and reputation) and close monitoring. He also deduces that that many angels invest with little formal protection because they are interested not only in financial return but in the joy of the entrepreneurial game and the prestige from backing exciting new ventures. He also suggests that the dichotomy between detailed venture capital contracts and casual angel investments is fading as the angel industry matures.

I say that Ibrahim’s avoidance of any neat model is brave because the result is that the paper does not pretend to any dramatic theoretical breakthrough. However, his description of a complex reality seems exactly right.

As he acknowledges, a major problem in studying angel investments is the lack of rigorous empirical data. This stems both from the novelty of the industry and from its informality; it is practically impossible to obtain details about thousands of individual investments in private companies. Accordingly, both his conclusions and my following comments are based more on conjecture than one would wish.

First, I think that the context of angel investments renders VC-like protections both less necessary and less beneficial in ways that the paper does not adequately recognize. For one, although angels do not formally arrange staged financing, in practice the firms in which they invest lack sufficient capital to go long without additional financing. Further, even without much contractual protection the investor can sue for breach of fiduciary duty. Even if the entrepreneurs accept the reputational damage of such a suit, its financial impact on the venture is likely to be fatal. In sum, the angel may have more power to force the firm into bankruptcy than the paper acknowledges.

Second, Ibrahim concludes that angels are either financially rational or are consciously pursuing non-financial interests. Here again more and better data would be helpful, but I suspect that there’s quite a bit of hubris here. Successful business people tend to assume that they are financial wizards when their success may stem from one good idea or entirely from luck. They think they know a winner when they see it, but I bet that the batting average of angels is pretty low. (Their incaution is probably reinforced by the typical entrepreneur’s dislike of lawyers and contracts.) Of course (as Ibrahim recogizes), those who get burned probably become either more cautious or simply drop out of angel investing. However, there’s always a new crop willing to play the same game.

Finally, I think the paper could give a little more attention to the future of the current trends that it discusses. Although there have always been wealthy individuals willing to finance a neighbor with an interesting business idea, only recently has there evolved something that could be called an angel investment industry. As the paper describes, this industry is already mutating with the appearance of angel investment organizations, whose members often eschew the casual approach of traditional angels in favor of stronger contracts that lie closer to the venture capital model. If this trend continues, the dichotomy between angel and venture capital investments may diminish further; only unsophisticated (foolish?) angel investors will persist in the casual approach.

Again, these comments are minor; the paper is excellent. I recommend it to everyone who teaches business associations as a fine, cutting-edge description and analysis of an increasingly important field.

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I want to start by thanking Christine, Gordon, and the rest of the ‘Glom gang for inviting me to participate as a commentator on Darian Ibrahim’s terrific paper, The (Not So) Puzzling Behavior of Angel Investing. Ibrahim’s paper works to explain a perceived puzzle: why are some investors defenseless against entrepreneurial agency costs, and others increasingly brawny and well-armored by law. Both kinds of investors are called "angels."

Ibrahim shows that traditional angel contracts (call them "TACS") are rational even though they are informal in the face of perceived agency costs. He does so by advancing several arguments: (1) traditional angels don’t really face the agency costs that VCs do, because they select for entrepreneurs they know and monitor them through informal networks of trust; (2) informal TACS facilitate later VC investments, and thus increase the probable payouts for angel investments; (3) TACS are low-stakes, and legal armor is expensive; and (4) TACS are not motivated by wealth maximization, but by altruism or thrill-seeking. It strikes me that these explanations, taken together, provide a pretty good account of why TACS are informal and VC investments are not, but it raises two sorts of problems for me about the paper, both of which are relatively minor and more a matter of emphasis than substance.

First, given this story, is it really true that angel behavior is a "marked departure" from financial contracting theory? That is, I was convinced that, in fact, angel uncertainty, information asymmetry, and agency costs may be ameliorated significantly by the mechanisms that Ibrahim describes. But the paper (especially in the introduction and the conclusion) sets up the findings as a dramatic surprise. This felt a little jarring.

Second, I found it difficult to square the two different accounts of angel behavior, on the one hand coldly wealth maximizing, and on the other, an indulgence of the very rich ("it’s cheaper and more fun than buying a yacht." (p. 26).) Are angels rational, or aren’t they?

Ibrahim might seek to harmonize this story by focusing more on the different kinds of angels, with particular emphasis on his observation that some investors are repeat players (whose exposure in the aggregate is likely to be higher, and whose may therefore be more willing to invest in contracting costs). There is a large literature on repeat-player contracts to be exploited here. This would help to transition the paper to the discussion of Angel Investment Organizations, which are (in this story) nothing more than collections of experienced investors. Such investors have learned from experience that contracting terms are efficient, but each individual contract is too small to justify the investment of a lawyer. Pooled resources maximize the investors’ returns. This explanation could transition into a discussion of how the angel market, far from being thin and inefficient as some have posited, is actually a place for experienced investors to fleece newcomers by doing better in the business of insuring against downside risk.

The problem with this kind of story is that it makes it different to distinguish angels from <strike>devils</strike> venture-capitalists. Both groups seek to maximize profits: some simply don’t have enough at stake to accomplish their goals through contracts. So what makes an angel an "angel?" Footnote 1 suggests that the difference between VCs and Angels really boils down to VCs’ responsibilities to their investors to make a return. (Thus tying the paper nicely into the literature about the behavior changing effects of agency rules.) But this explanation doesn’t totally satisfy, because the evidence collected about angel behavior doesn’t seem to exclude corporate or merely middle-class angels. Ibrahim is careful to note that Angels would have difficulty making a claim of minority oppression in most courts. But I imagine that in other contexts, Angels might benefit from their names, and general reputations for benevolence. This suggests another reasons for angels to avoid legal controls: to preserve their general aura.

Overall, I thought this was a provocative, easy-to-read, and wonderfully stimulating paper. Ibrahim notes that much empirical research remains to be done about these secretive investors. Given some of his conclusions, I agree that a particularly ripe area of research (see page 16 of the paper) would employ a "more refined taxonomy of traditional angels." But additionally, it seems that many angels do employ traditional control mechanisms (20-42.5 percent seek a board seat; 60% seek preferred stock). Are such angels differently situated from other less protected members of the choir? Finally, I think that Ibrahim could tie the paper a bit more to the (Stout/Huang/Ribstein etc.) trust and contracting literature by employing some qualitative research. Is it really true, for example, that entrepreneurs would feel that proposed control terms create a trust-problem? Given the statistics offered about the demand for angels, I would have thought that an angel investment contract would be a bit like a ticket to a Bruce Springsteen concert. No one would read the flip side.

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Welcome back to the Conglomerate Junior Scholars Workshop.  Today's paper is Alexander "Sasha" Volokh's Privatization and the Law and Economics of Political Advocacy.  Sasha is a Visiting Assistant Professor at Georgetown University Law Center where he teaches Law and Economics, Regulation Law and Economics, Environmental Economics and the Law, and Delegation and Privatization.  To do justice to a paper written by an economist, I had to call upon two distinguished economists who are experts in the field of law and economics, Tom Ulen and Paul Rubin.  In addition, Brian Galle, former workshop participant, has provided valuable feedback.

We invite readers to comment on the paper (and the comments) in the comments section of this post.  In the interest of running this workshop like a physical world conference, no anonymous commenters, please.

The abstract for the paper is here:

A common argument against privatization is that private providers will self-interestedly lobby to increase the size of their market. In this Article, I evaluate this argument, using, as a case study, the argument against prison privatization based on the possibility that the private prison industry will distort the criminal law by advocating for incarceration.

I conclude that there is at present no particular reason to credit this argument. Even without privatization, government agents already lobby for changes in substantive law—in the prison context, for example, public corrections officer unions are active advocates of pro-incarceration policy. Against this background, adding the “extra voice” of the private sector will not necessarily increase either the amount of industry-increasing advocacy or its effectiveness. In fact, privatization may well reduce the industry’s political power: Because advocacy is a “public good” for the industry, as the number of independent actors increases, the dominant actor’s advocacy decreases (since it no longer captures the full benefit of its advocacy) and the other actors free-ride off the dominant actor’s contribution. Under some plausible assumptions, therefore, privatization may actually decrease advocacy, and under different plausible assumptions, the net effect of privatization on advocacy is ambiguous.

The argument that privatization distorts policy by encouraging lobbying is thus unconvincing without a fuller explanation of the mechanics of advocacy.

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Privatization is hot. For the past 30 years or so, many counties have been rethinking what governmental duties should be in public hands and which in private hands, as well as the appropriate scope of governmental regulation of private entities. The trend has been toward placing fewer social functions in public hands and more in private hands and toward less regulation. These developments are observable most dramatically in the transition economies and the developing world, where the distance to be traveled from state domination was greatest.

But they are also observable in the developed world, including the United States. Consider these examples: the State of Indiana has turned over management of the Indiana Toll Road to a private corporation; the federal government has turned over the management of many of the national parks to private companies; the Bush Administration proposed in 2005 that the privatization of the Social Security System, a move that several other countries have already made; and both the federal and state governments have invited private profit-maximizing corporations to take over a substantial and increasing fraction of their incarceration obligations (about which more in a moment). Recently, the Governor of Illinois proposed that the operation of the State’s lotteries be leased to a private entity for a period of 75 years in exchange for a lump-sum payment of $10 billion, to defray part of the $41 billion unfunded liability of the state pension systems. (The Illinois House defeated the proposal 78-6.) And it is only a matter of time before some states seek to privatize their public universities.

There are numerous arguments in favor of each of these instances of privatization. One is that there was no compelling reason for these activities to be managed by public rather than private entities. In some instances, these privatizations are corrections of mistakes made long ago. In others, the technology of production and distribution has changed so that the case for public ownership is no longer compelling: public utilities are good examples. Another reason for privatization is a desire on the part of governments to raise revenues without increasing taxes (as in Illinois). Like a distressed business or individual, they are selling off their valuable assets.

But there are also arguments to be made against some privatizations (but not against all privatizations). Economists distinguish between public and private goods and generally hold that public entities (or closely regulated private entities) should provide public goods while private entities provide private goods. (The principal reason for this distinction is that private entities will provide a socially suboptimal amount of a public good. Of course, a private entity could be induced to provide more of a public good if the government were to subsidize its costs of production or its output price.) So, economists tend to break out in rashes if the government proposes to privatize an essentially public good, like national defense or, as happened several years ago with disastrous results in my home town of Champaign, fireworks displays.

Additionally, anyone, not just economists, might grow nervous if the government privatized for inappropriate reasons—for instance, to enrich a campaign contributor or pursuant to an agreement not to disclose embarrassing or sensitive information.

Finally, one might be opposed to privatization because it might create a powerful political constituency that might have a potentially deleterious effect on public policy debates. Interest groups who do or might benefit considerably from particular policies have a strong incentive to seek to influence government to adopt (or not to change) those policies. Thus, by privatizing some governmental duties, the government may be creating a new interest group that will seek to influence public policy in its favor. This was precisely one of the contentions of those who opposed the privatization of Social Security: their fear was that the private, profit-maximizing companies who were to manage the billions of dollars in Social Security assets might become deeply invested in nudging public policy so as to increase their returns on those assets. To take but one example, if those managing firms were heavily invested in the shares of companies that created environmental harms, they might then have a powerful incentive to lobby the state and federal governments not to enforce environmental regulations more assiduously because those actions might increase the costs (and thereby lower the profits) of the firms in which they were heavily invested. And the government might be inclined to listen to this lobbying because of its concerns for the solvency of the Social Security System.

Alexander Volokh’s "Privatization and the Law and Economics of Political Advocacy" is a first-rate discussion of this latter concern about privatization. The article elaborates a simple but powerful model of political advocacy and then uses the predictions of that model to examine the behavior of those involved in the private prison market. The upshot of this examination is that whatever else one might say about privatization, at least in the case of private prisons the prediction that the privatized firms or those who work for them will seek to influence public policy in a socially adverse fashion is not borne out.

I shall briefly describe Volokh’s model of political advocacy, paying special attention to its predictions, and then briefly summarize its application to the matter of private prisons. I find the article so well-written and so persuasively argued that I have only some minor suggestions for improvement and for future work to pursue.

Volokh begins the development of his model of political advocacy by noting that a monopolist has exactly the right incentives to decide how much advocacy to engage in. The costs and benefits of advocacy accrue to one firm. So, that firm has every reason to calculate the net benefits, if any, and to engage in a privately optimal amount of advocacy. But suppose that a second firm appears and takes 10 percent of the market. Now, the benefits of political advocacy by the firm with the 90-percent market share accrue in part to the other firm. And this will, Volokh argues, tend to reduce the amount of political advocacy that the larger firm engages in. Because, for similar reasons, the smaller firm will have no incentive to engage in industry-increasing political advocacy, the total amount of political advocacy is likely to decrease.

The principal insights here are that "industry-increasing political advocacy is a public good" and that "[p]rivatizing part of the industry therefore introduces a collective action problem." (p. 10.) If one imagines, as seems to fit many instances, that privatization results in a continuing and large public sector and a smaller private sector, then the upshot of privatization is that the amount of advocacy will decrease, for two reasons. First, the small private sector—like the firm with a 10 percent market share—will engage in no advocacy. They will choose, rather, to free ride on whatever industry-increasing advocacy the larger firm chooses to do. Second, the public sector—like the former monopolist now left with a 90 percent market share—will cut back on advocacy because it is enjoying only a fraction of the benefits.

Let me make two brief comments about this fascinating model. First, although I do not question the basic correctness of the model, I wonder if Volokh might take some time to investigate another implication. If the collective action problem of political advocacy in a non-monopolized industry is so evident, isn’t it likely that many industries that face the problem have found methods of surmounting the problem? After all, K Street in Washington, DC, and similarly situated streets in every state capital are lined with the offices of lobbyists who put the case to political decisionmakers on behalf of numerous industry associations. How have those lobbyists been able to persuade the disparate members of industries—some of which are, no doubt, mixtures of public and private sectors like those imagined by Volokh—to contribute to the association’s lobbying efforts on behalf of all? How do they punish or exclude nonpayers from the benefits of their advocacy? Volokh notes that a concentrated industry is more likely to be able to find a method of solving the collective action problem. Are there some examples from the privatization experience?

Second, I would urge Volokh to look at and cite the literature on experimental public goods games. The gist of many of those games is that people tend to invest far more in public goods than simple self-interest would seem to dictate. This effect is particularly strong in repeated games. Why might this be important to Volokh’s theory? If real people tend to invest in public goods games in instances like those that characterize the circumstances of political advocacy, then, contrary to the prediction of the model that Volokh has carefully articulated, perhaps the same or even more political advocacy happens after privatization as happened before.

These possibilities—that industries find a way to solve the collective action problem and that real people facing public goods issues do not behave in the manner that economists hypothesize that they might—deserve some attention.

The second half of Volokh’s paper applies the model to the facts about private prisons. The fascinating information in those pages (on the percentage of prisoners in federal and state prisons who are being supervised by private firms, on the amount of money spent by and the policies advocated by the California Correctional Peace Officers Association, on the anti-incarceration advocacy of nearly every state director of prisons, and so on) is not to be missed. Volokh makes the case very persuasively that privatization has not resulted in an increase in advocacy for incarceration. Indeed, Volokh reports that he has "found a single piece of advocacy of arguable pro-incarceration advocacy by a private firm." (p. 31.) And "there is little hard evidence that private firms advocate stricter criminal law at all." (p. 32.)

Let me conclude with two brief comments about where to go next with this superb work. First, I would very much have liked Volokh to take a swing at this pitch: how generalizable are your findings about prisons to other instances of privatization? Would the privatization of Social Security have been a disaster? How about the privatization of public roads, public universities, and state lotteries? Clearly, the more likely it is that privatization does not have adverse social effects on public advocacy, then there is one less matter to worry about in debates about privatization.

Second, near the end Volokh raises a fascinating research possibility. What explains the pattern of privatization among the states? Why have some states embraced privatization while others have not? Professor Volokh, speaking only of the privatization of prisons, cites only one factor: "The states where privatization has gained a foothold aren’t randomly chosen; rather, privatization emerges where corrections officers’ unions are weak and fails to emerge where the unions are strong." (p. 47.) There are no doubt other factors—such as the prevailing political majority party, the mix of rural and urban, demographic factors in the state, and the recent growth rate of the economy—that might play a role in a state’s willingness to privatize prisons and other governmental activities. I very strongly encourage Professor Volokh to pursue this econometric study.

One more matter. I wish that matters of privatization, like all matters of public policy, were decided by appeal to the clear thinking exhibited in this article. And I wish that the public debate on these matters was vigorous, informed, and capable of changing people’s minds. Alas, it is not. (See Louis Menand, "Fractured Franchise: A Review of Bryan Caplan, The Myth of the Rational Voter: Why Democracies Choose Bad Policies (2007)," The New Yorker (July 9 & 16, 2007), at 88-91 and www.newyorker.com, and Arthur Lupia, "Deliberation Disconnected: What It Takes to Improve Civic Competence," 65 Law & Contemp. Probs. 133 (2002).) Nonetheless, those who value reason must keep trying: if their efforts are as lucid and persuasive as Alexander Volokh’s, they will, I hope, have an impact.

Finally, one has got to love a law review article that cites the estimable Canadian band, Bare Naked Ladies, for support of an assertion regarding the theory of second best.

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There are many good things about this paper. Volokh considers the argument that privatization is harmful because it creates private sector lobbyists for expansion of programs. He considers this in particular with respect to the issue of private prisons and lobbying for increased imprisonment. He does a nice job of showing that this is incorrect. The model he relies on is basically the Olson (1965) model of free riding in interest group formation and activity. He shows that by moving from a monopolistic (government) supplier to a more competitive set of suppliers lobbying can actually decrease. Thus, those commentators who have argued against privatization because they do not like imprisonment have it exactly backwards. In this case, the government lobbyists for increased use of prisons are guards and their unions, rather than the prison system administrators (who actually often lobby for smaller prison systems and more use of alternatives.) This is a nice point and an interesting application of Olson’s theory to an area that has not much been considered.

I have a couple of comments on the paper. First, it could do more with the state issue. Lobbying for increased imprisonment and sentencing would occur at the state, not federal or national level. Thus, data and arguments based on the relative size the national private prison market and the national public prison market would not be relevant. Volokh does spend some time talking about California, so there is some corrective, but there is some confusion. Moreover, it might be possible to develop some hypotheses about the issues being discussed that could be tested using state data, and a greater discussion of state differences would facilitate this analysis. For example, Sasha suggests that there is more prison privatization in states with weaker unions. This would seem to be a hypothesis that could be tested; since he is familiar with the data and issues, he could have fleshed out this argument with some suggestions as to how to test it. There may be other testable hypotheses as well. I am not suggesting that he should have tested these hypotheses, only that he might have made some suggestions as to how to test them.

Second, there is another version of this paper available on SSRN, "Privatization, Free Riding, and Industry-Expanding Lobbying." (This is cited in note 38 of the target paper.) The second paper is mathematically dense and would not be suitable for a law review. Nonetheless, I think a little more of the flavor of the mathematical version would have somewhat improved the target paper. However, this is a matter of taste.

Third, the paper is too long . For example, virtually the same information is in the mathematical version of the paper, which is 19 pages including lots of math; the Stanford version is 55 pages and 243 footnotes. That seems to be a general problem of law reviews, not one specific to this paper. Nonetheless, it is certainly true that more people would read a shorter paper (if it could get published.)

Nonetheless, this is a very nice paper and one that makes a very interesting policy point.

Olson, Mancur (1965), The Logic of Collective Action: Public Goods and the Theory of Groups, Harvard University Press.

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"Privatization and the Law and Economics of Political Advocacy" is a fun read and a smartly argued paper.  A few of its conclusions strike me as slightly oversold, but it is certainly on solid ground in its central claim that the effects of privatization on total industry lobbying effort are complex and hard to measure directly.

Professor Volokh's analysis begins as an elaboration on the classic Mancur Olson theory that lobbying effort creates positive externalities for other similarly situated firms, leading to underprovision of lobbying.  His insight here is that this dynamic may hold true for private prison operators (ppo) and public-sector prison-guard unions.  Thus, a critical point for the paper is to establish that the unions and the ppo in fact are similar enough to free ride on one another's lobbying.

At this point I'm not fully sold on that proposition.  If the union is a perfect agent for its members, it should be largely indifferent to the welfare of non-members.  Current members should benefit only slightly from expanding prison populations: prison crowding may make their jobs more secure, and increase their overtime pay, but there are limits on those benefits, and they are balanced to an extent by the likelihood that crowding increases their personal risk.  Larger union membership might increase union "clout" but also increases agency costs and diminishes each member's control over the union.  (I assume here that all public-sector jobs are unionized, so that there is no need to expand union coverage to prevent capital shifting to non-union firms.  But that seems a safe assumption, since if many public prison jobs were non-unionized, much of the analysis of the paper would break down.)  In contrast, the ppo can have essentially unlimited benefits from expanding prison populations.  So the marginal returns to lobbying effort for the union diminish much faster.  They may diminish fast enough that even a rather small ppo sector will want to make its own expenditures.   

Another difficulty with the assumption that unions and ppos will free-ride off each other is that political influence, once acquired, may serve many purposes and the interests of the two actors are often antagonistic.  This is likely true of oligopolies generally.  Lobbying can be both pie-dividing and pie-expanding.  Unless we know what our competitors are doing with the influence they acquire, we can't trust them to spend solely to expand the pie rather than expand and also slice in their own favor.  As Prof. V demonstrates, there is no easy way for one side to know just how the other is using its lobbying influence.  Both must therefore spend their own money. 

Relatedly, and as Prof. V. acknowledges, if lobbying efforts can be cashed out in a variety of ways once sunk, and each actor also has incentives to lobby for policies other than the one producing the externality, then adding additional actors may increase overall lobbying effort.  Prof. V's  response to this point (at 34-35) is to assume that political capital, like cash, is dissipated when used.  But his only authority for that claim is a cf. cite to an anecdote from a NY Times article.  We could certainly tell alternative stories on that front.  For instance, there could be relational capital -- e.g., officials may give favors based goodwill built from past encounters, or may be generous in order to pave the way for future contributions.  In short, I'd like to see more discussion of this point.

Finally, another key assumption of the paper is that public-sector unions are likely to be the dominant lobbying actor because they command a larger "share" of the relevant market -- that is, they realize most of the benefits from pro-incarceration lobbying.  These benefits are said to come in the form of above-market salaries, measured by comparison to "private-sector corrections officers' wages."  (21-23 & n.68)  Again, I'd like to hear a lot more on that point, given its centrality to the analysis.  Are public and private sector officers similar, or are public sector more qualified?  Do public employees have to pass background checks private officers don't? Or are private sector jobs safer, because private firms "skim" the safest (i.e., the cheapest) populations?  The "rents" commanded by public sector workers might be a risk premium.

Most of these points, however, go to the question whether privatization in fact decreases pro-incarceration lobbying.  For the most part, the Paper (wisely, in my view) eschews making a final judgment on that point, and instead offers us a highly accessible and thoughtful introduction to the complexities of the issue.  At points, though, it reaches a bit further, especially in the conclusion (for example, at 51 and 53). (""My opinion, based on the above theory and evidence, is that privatization will probably not worsen any political influence problem, and may alleviate it.")  I'm not sure what "evidence" we're talking about here; Prof. V. acknowledges earlier that the empirics he surveys are inconclusive.  This paper is interesting enough without over-claiming.  I'd trim these passages (and, not be a killjoy, I'd also cut most of the barrage of unfunny joke footnotes that pop up in the conclusion as well.  "They all deserve to [go]."  I mean -- the Star Wars quote?  That was forced.)

In the meanwhile, I'll look forward to the next dispatch from this talented writer and scholar.

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Thanks to all who participated this week in our workshop, which featured Trey Drury's What's the Cost of a Free Pass?  A Call for the Re-Assessment of Statutes for the Elimination of Personal Liability for Directors.  Comments are still open below.

Next week we conclude the workshop with our final two papers.  On Monday, the workshop will feature Sasha Volokh's paper Privatization and the Law and Economics of Political Advocacy.  Our expert commentators will be Paul Rubin, Tom Ulen and former workshop participant Brian Galle.

On Wednesday, the workshop will conclude with Darian Ibrahim's paper The (Not So) Puzzling Behavior of Angel Investors.  Our expert commentators for Darian's paper will be Barbara Black, Larry Ribstein and Dave Hoffman.

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Welcome back to the Conglomerate Junior Scholars Workshop.  Today's paper is Trey Drury's What's the Cost of a Free Pass?  A Call for the Re-Assessment of Statutes that Allow for the Elimination of Personal Liability of Directors.  Trey is a Visiting Assistant Professor at Loyola Law School in New Orleans.  Trey was originally scheduled to participate in the first Junior Scholars Workshop two years ago with this paper, but plans were derailed by Hurricane Katrina.  We're glad that he's back in NOLA and has resumed his stint at Loyola.  Before entering law teaching, Trey practiced for eight years, including a stint in the general counsel's office of Entergy.

Our commentators today are also experts on this topic:  Joan Heminway, Lisa Fairfax, Elizabeth Nowicki and former workshop participant Matt Bodie.  I will post the comments of these experts below this post throughout the morning.  We invite readers to comment on the paper (and the comments) in the comments section of this post.  In the interest of running this workshop like a physical world conference, no anonymous commenters, please.

The abstract for the paper is here:

The 1985 Delaware Supreme Court decision in Smith v. Van Gorkom caused considerable unrest among members of corporate boards and their legal advisors. In that case, board members were held personally liable for a breach of their fiduciary duties, even though no conflict of interest existed. Many observers were taken aback by this result, and a public outcry followed. The consequences of this decision, particularly the perceived crisis in securing directors & officers liability insurance, spurred some legislatures into action. By 1986, Delaware had already enacted a statute enabling a corporation to limit or eliminate the personal liability of directors for breaches of their duty of care. Some version of this approach has now been implemented in all fifty states, and virtually all of the nation's largest corporations include these exculpatory provisions in their charters.

This Article argues that the time has come to re-examine these statutes, and that this re-examination points to a need to improve the status quo. Part I of this Article describes the Smith v. Van Gorkom holding, and the subsequent decision in Delaware to allow corporations to remove the prospect of personal liability for directors for duty of care breaches. Part II argues that these exculpatory statutes, in their current form, are doing harm to shareholders and to the orderly function of corporate law. First, this Part demonstrates that the existence and current use of the statute incentivizes board members to engage in sub-optimal behavior. Second, the Part questions the legitimacy of the original stated need for enacting the statute. Third, this Part claims that another area of corporate law, judicial interpretation of the duty of good faith, is being manipulated to circumvent the restrictions placed on courts by corporations that choose to eliminate liability for breaching the duty of care. Part III then introduces the contractarian theory of the firm in support of the current statute, examines the limitations of that theory, and explores the implications of the theory in determining the proper course of action. Finally, Part IV recommends actions available to dissatisfied shareholders, including a specific improvement in the mechanics of the statute – the addition of a requirement that shareholders must reapprove an exculpatory charter provision at least every five years.

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Thanks, once again, to my buddies at the Glom for giving me the opportunity to participate in this forum.  Yet again, I was asked to read and comment on an interesting piece of scholarship.

Having just taught a Comparative Mergers & Acquisitions course using Steve Bainbridge's Mergers and Acquisitions book, I found the first few sentences of Prof. Trey Drury's working paper "What's the Cost of a Free Pass?  A Call for the Re-assessment of Statutes that Allow for the Elimination of Personal Liability for Directors" particularly salient.  In these sentences, he notes the built-in tension between authority and accountability in the corporate form (which is a central theme in the Bainbridge text and numerous other scholarly works).  This necessary authority/accountability struggle is central to Drury's argument in the paper.  It is because of a perceived negative imbalance in that struggle--weaknesses in the accountability structure emanating from the statutory enablement of director exculpation--that Prof. Drury suggests modifying existing exculpation statutes to allow shareholders to periodically vote endorsement or disapproval of charter exculpation provisions.  He also suggests giving shareholders the power, as I understand it, to initiate binding proposals for charter amendments to delete or reform exculpation provisions.  Finally, he suggests repeal of the statute, but characterizes that option as undesirable.  Each of these suggestions is intended to increase accountability while preserving authority and promoting shareholder choice.

On one level, as a former practitioner, I have to like Prof. Drury's suggestion that shareholders periodically ratify exculpation provisions.  This suggestion will help keep lawyers involved in the annual meeting proxy process in a more substantive way than they otherwise might be.  (Prof. Drury's suggestion does not quite provide full employment for securities lawyers, but it certainly is a positive development!)  Looking at the proposal from a less jaded perspective, however, I must wonder whether the transaction costs associated with Prof. Drury's suggestion offset the potential benefits.  I think it unlikely that shareholders actually will exercise their franchise rights in a meaningful way if given the choice to expressly ratify exculpation provisions in corporate charters.  Accordingly, I wonder if it really
does enhance accountability at all.  I would like to see the paper better substantiate that claim.  I have similar (and other) concerns about the suggestion to give shareholders new charter amendment powers
and more significant reservations about repealing the enabling statute.  In general, I would like to see Prof. Drury better support his proposed solutions in a future draft.  Perhaps he should focus narrowly on one or two ideas (instead of three) and show more clearly in the last part of his paper how any proposed fixes counteract his earlier critiques of the existing framework.

I must note before closing that Prof. Drury's paper is very readable and makes a number of important points along the way about exculpation statutes--as to attendant director behavioral incentives, suitability and efficacy, the channeling of fiduciary duty actions into good faith claims, and unappreciated beneficial effects.  I agree with some of these observations, and not with others.  But that's the nature of analyses involving fiduciary duty in the wake of Disney, isn't it?  Some of us think the system ain't broke, and others think we need a fix but cannot agree on why or what.  I am confident that this paper, in its final form, will contribute new insights to the literature in that latter category.

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Trey Drury has written a thoughtful piece on Delaware’s 102b7 and its drawbacks.  As he notes, his article and 102b7 essentially seek to find a balance between corporate authority and accountability.  His article suggests that the statute in its current form undermines accountability in a number of important ways.  In an effort to correct this shortcoming, he offers a solution—legislative action that would require periodic reauthorization of the 102b7 by shareholders.  The solution is an interesting compromise because it appears to preserve the benefits of 102b7 while allowing shareholders genuine ability to opt out of those benefits if they choose (or at least to reevaluate them).  Yet I must admit that I am not sure if his solution will create real change or it will amount to mere rubber-stamping of the status quo.

Trey’s article starts with a nice examination of the events leading up to the passage of 102b7—namely Van Gorkom and the potential for too much personal liability for directors as well as the perceived crisis in the D&O insurance market created by Van Gorkom.  Here Trey does a good job of capturing the concerns generated by Van Gorkom and reminding the reader that not all agreed with the severity of those concerns.

First, Trey notes that the statute appears to create incentives for directors to engage in sub-optimal behavior.  Here Trey discusses the notion that, because directors can avoid personal liability for breaches of duty of care, directors are less likely to be diligent in carrying out their duty.  While agreeing with that concept, I think the article would benefit from a more an in-depth discussion regarding the impact of liability regimes on director behavior, especially in light of those who insist that such regimes have no little to no impact on corporate behavior.  Trey also notes a subtler manner in which 102b7 impacts issues of corporate governance.  Here Trey maintains that 102b7 allows directors to avoid 10B-5 liability.  This is because10b-5 requires scienter, yet because 102b-7 incentivizes directors to be inattentive, the statute makes it difficult to prove scienter because the statute makes it less likely that directors will have the knowledge necessary for such proof.  I found this discussion intriguing because I think there is a connection between the way in which directors’ carry out their duty of care and the ability to bring securities fraud actions.  However, I am not sure if the article made that connection in a convincing fashion.  Indeed, the article focused on the notion that 102b7 creates incentives for directors to be less attentive and less informed regarding corporate affairs.  Yet the article did not really discuss the impact of SOX and other new federal rules regulating corporate conduct.  Indeed, the studies I have read suggest that since SOX, directors and officers have been paying more attention to their obligations, spending more time on governance mattes and becoming more entwined in corporate operations.  How do such studies impact the article’s analysis regarding scienter?  Moreover, it seems like demonstrating scienter in the corporate context is a difficult proposition in and of itself.  Is it really the case that 102b7 significantly enhances that difficulty?  Put another way, is there any evidence—empirical or anecdotal—that there is a link between demonstrating scienter and the adoption of 102b7?  I think this portion of the article would benefit from a more detailed discussion of these issues.

The next section of the article notes that the problems that 102b7 were designed to resolve may in fact be resolved.  Thus, the article points out that the issues associated with the D&O market may have been exaggerated.  Then the article notes that courts appear to have addressed many of the concerns associated with Van Gorkom regarding issues of uncertainty and the potential for too much personal liability.  Here I think Trey’s argument has a lot of merit, and that the argument would be enhanced by pinpointing some of the language and commentary regarding cases such as Disney, which suggest that while courts are willing to articulate a seemingly higher standard of care for directors and officers, they are not willing to impose liability for defects in the exercise of that care.

The article then points out that 102b7 has caused courts to rely on good faith as a way to get around the prohibitions in 102b7 and enable shareholders their day in court.  Trey makes a good point what while the focus on good faith may seem to vindicate shareholders by allowing them their day in court, it comes at a cost—namely greater uncertainty, given the ill-defined nature of the good faith doctrine. The article also focuses on the limits of the contractarian theory.

Finally, the article proposes a solution that in many ways is consistent with the contractarian theory because it allows shareholder true choice in the exercise their contract rights—that is, it allows shareholder to re-authorize 102b-7.   Trey notes two possibilities for reauthorization—through shareholder proposals or through legislation.  He maintains that collective action and rational apathy problems makes the shareholder proposal route less attractive than legislation where corporations would be required to put reauthorization on the ballot.  However, I am not sure that legislation really overcomes the problems of collective action and rational apathy.  To be sure, the measure will be on ballot.  But it seems that it would suffer the same fate as other issues shareholders vote upon—that is, shareholders, because of collective action problems and rational apathy, will follow the advice of management. Indeed, the article does not discuss why we should expect shareholders to be more attentive in the context of the reauthorization vote that they are in other contexts.  Of course it is possible that the new wave of shareholder activism will mean that any shareholder vote on reauthorization will be meaningful because that activism suggest that shareholders will play a greater role in governance matters. But such a possibility needs to be addressed.

In the end, I found the piece thoughtful and insightful.  I certainly welcome articles that seek to explore how we can revitalize the threat of personal liability in order to strike a better balance between corporate accountability and authority.

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Perhaps nothing in the Business Associations course creates more student cynicism than Del. Code Ann. tit. 8, § 102(b)(7). This statutory subsection allows corporations to eliminate whatever personal liability their directors may have incurred for breaches of the duty of care. Of course, the discussion of § 102(b)(7) only comes after students have already seen the duty of care pretty much eviscerated by the business judgment rule, indemnification, and directors’ & officers’ liability insurance. After having wrapped their minds around these concepts, students may see § 102(b)(7) as a cruel joke, a form of legislative overkill. But there it is at the end of the "duty of care" chapter – the last nail in the coffin for the seemingly reasonable duty of care.

Lloyd Drury takes on § 102(b)(7) in his article, "What’s the Cost of a Free Pass? A Call for the Re-assessment of Statutes that Allow for the Elimination of Personal Liability for Directors." Drury argues that § 102(b)(7) and its companions in other states are "doing harm to shareholders and to the orderly function of corporate law." (p. 6) Instead of calling for their elimination, Drury argues that such provisions should be reapproved by shareholders every five years. In constructing this argument, Drury discusses Smith v. Van Gorkom and the history of § 102(b)(7); director liability under federal securities law; the budding development of the duty of good faith; and the contractarian theory of corporate law. Ultimately, I fear that Drury’s effort to be comprehensive renders his article too overextended in making its point.

Drury starts off his paper with an attack on the premise behind § 102(b)(7). He discusses the Van Gorkom case and the crisis on the D&O insurance market that led to § 102(b)(7)’s passage. Drury argues that § 102(b)(7) went too far in allowing companies to absolve their directors of all personal liability, because such absolution skews directors’ incentives away from good conduct. Drury is fairly balanced in making this claim: he presents the argument from scholars such as Hillary Sale, Lisa Fairfax, and Lynn Stout, as well as counterarguments to their concerns. But he is traveling over well-trod territory here, and he does not have an angle that sharpens his argument to a point. His claim about § 102(b)(7)’s inefficiency ultimately rests on general notions of incentives, anecdotal discussions of WorldCom and Enron directors, and a 1989 event study by Michael Bradley and Cindy Schipani. The Bradley & Schipani study found abnormal negative returns to the share prices of Delaware firms in the wake of § 102(b)(7)’s enactment. While this empirical data is powerful, Drury relies on it too much without placing it within the context of the overall literature. Have law and finance scholars reached consensus on the inefficiency of liability waiver statutes? Drury’s paper would be more powerful if he provided us with this context, particularly since the one empirical finding plays such an important role in his argument.

Drury also criticizes what he sees as the collateral consequences of liability waivers. Drury argues that due to § 102(b)(7), the Delaware courts have been forced to use the amorphous duty of good faith to handle director failings that were traditionally the province of the duty of care. He argues that this is a problem because good faith is too ill-defined, and because this use of good faith prevents shareholders from legitimately using § 102(b)(7) to get rid of gross negligence liability. Because good faith is such a small part of his paper, Drury can only provide a brief summary of the duty and its recent appearance in the Disney case. However, in the wake of Chancellor Chandler’s opinion in Disney, the Delaware courts have actually developed a definition of the duty of good faith that is much narrower than Drury’s article implies. Although it remains an issue for further development, the duty of good faith does not seem poised for significant expansion (the efforts of my co-commentator notwithstanding).

Drury’s suggested reform is a reasonable and intriguing one. Despite his concerns about its inefficiency, Drury does not argue for the elimination of § 102(b)(7). Instead, he uses the contractarian theory of the corporation to argue that shareholders should have to reapprove the liability waiver every five years. This solution seems sensible, and it seems to fit within the ongoing movement for greater shareholder empowerment. In fact, I would have liked to see Drury place his argument within this literature. The notion of reapproval as a meaningful reform requires (1) the possibility of changing circumstances that may lead to the waiver failing to get approval, and (2) an active shareholder base that would intelligently consider the decision in light of these circumstances. Many corporate law scholars would argue (Stephen Bainbridge, perhaps?) that these conditions do not hold, and thus the reapproval process would largely be a waste of time. Drury needs to establish that shareholders can be actively involved, and that they will make meaningful choices to reaffirm or to end their company’s director liability waiver. Without these, the reapproval process seems like an empty, formalistic exercise. The "shareholder empowerment" literature is the best place to go in establishing the effectiveness of shareholder reapproval. Indeed, much has been written recently about developing ways in which shareholders could have more access to the levers of corporate power. Drury could easily situate his article within this body of scholarship.

In sum, I was impressed with the variety of topics that the article endeavors to cover on its way to making a modest and thoughtful proposal for reform. But I would like to see the paper less concerned about covering these background issues and much more focused on the foreground. Drury needs to connect his notion of shareholder involvement (through the reapproval process) to his more general concerns about the inefficiency of liability waivers. If he does this, I believe his paper will be a real contribution to the literature on this subject.

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Thanks to all who are following the Conglomerate Junior Scholars Workshop.  If you missed the discussion on this week's two papers, the posts are below:  David Friedman's Reinventing Consumer Protection and Miriam Baer's Insuring Corporate Law.

Next Monday, our paper for presentation will be What's the Cost of a Free Pass?  A Call for the Re-Assessment of Statutes that Allow for the Elimination of Personal Liability for Directors by Trey Drury.  Our expert commentators will be Lisa Fairfax, Joan Heminway, Elizabeth Nowicki and former workshop participant Matt Bodie.

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Welcome back to the Conglomerate Junior Scholars Workshop.  Our paper today is Insuring Corporate Crime by Miriam Baer.  Miriam is an Acting Assistant Professor in NYU's Lawyering Program.  She also is well-acquainted with her topic; Miriam was an assistant U.S. attorney in the Southern District of New York from 1999 to 2004.  Our commentators today are also experts on this topic:  Sean Griffith, Kim Krawiec and former workshop participant and commentator Mike Guttentag.  I will post the comments of these experts below this post.  We invite readers to comment on the paper (and the comments) in the comments section of this post.  In the interest of running this workshop like a physical world conference, no anonymous commenters, please.

The abstract for the paper is here:

Corporate criminal liability has become an important and much-talked about topic. This Article argues that entity-based liability - particularly the manner in which it is currently applied by the federal government - creates social costs in excess of its benefits. To help companies better deter employee crime, the Article suggests the abolition of entity-wide criminal liability, and in its place, the adoption of an insurance system, whereby carriers would examine corporate compliance programs, estimate the risk that a corporation's employees would commit crimes, and then charge companies for insuring those risks. The insurance would cover the entity's civil penalties associated with its employees' criminal conduct. Entities that successfully procured insurance would no longer be subject to entity-wide criminal liability. Part I begins with a discussion of corporate criminal liability and the costs that accrue from the manner in which it has been implemented by the Department of Justice. Part II examines several proposals to reform corporate criminal liability and explains why they are inadequate. Part III lays out the proposal for an insurance system in lieu of entity-based criminal liability and explains, in rough form, how corporate entities might contract for insurance, how claims might be filed and how damages might be measured. Part III also addresses a number of arguments that others might raise against the proposal.

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Many thanks to Christine and the other Glommers for inviting me to comment on Miriam Baer’s timely and provocative draft, Insuring Corporate Crime. In this piece, Baer advocates the abolition of corporate criminal liability, thus shifting determinations of entity liability for employee wrongdoing into the civil liability system. In exchange, corporations would be required to procure "compliance insurance" policies that would cover the entity’s civil penalties associated with employees’ criminal conduct.

Baer contends that her proposed system would rectify the tendency toward overly expensive monitoring and compliance systems and suboptimal settlement terms common in the composite corporate criminal liability system, eliminate "mindless devotion to compliance for the compliance industry’s sake," and encourage more efficient levels of risky corporate activity and liability avoidance. Although I am sympathetic to Baer’s concerns, I fear that her proposal, as currently envisioned, will not ameliorate many of the inefficiencies of the corporate criminal system that she so carefully identifies.

Let me begin by addressing the paper’s strengths, of which there are many. As Baer notes, commentators have long debated whether corporate criminal liability provides benefits unattainable by the civil system. In this paper, Baer provides yet more ammunition to those who would eliminate corporate criminal liability. She persuasively documents problems with corporate criminal liability stemming from prosecutorial discretion, conflicts of interest created by prosecutors’ willingness to provide lenience to the corporate entity in exchange for targeting culpable individual employees, and the high costs often associated with a corporate criminal indictment (which can include the loss of licenses, permits, and an inability to participate in certain regulated industries).

But the bulk of the paper is reserved for a critique of the compliance-based corporate criminal liability system, as detailed in the OSGs and implemented by prosecutors (with guidance from the McNulty and Thompson memos). This is where I begin to resist Baer’s proposal, not because she errs in her skepticism toward compliance-based composite liability systems (indeed, I share her cynicism on this point), but because the same compliance-based composite system that she lambastes in the corporate criminal liability system also pervades the corporate civil liability system. As a result, Baer’s proposal, which relies on a shift from criminal to civil liability, is unlikely to deliver the promised benefits of a movement away from overly costly and uncertain compliance-based liability and a reliance on the compliance industry that promotes it.

The pervasiveness of, and problems inherent in, compliance-based liability in the modern civil and regulatory systems have been much discussed, not only by legal scholars, but by theorists in sociology and management science as well. Although the role of compliance and monitoring systems in employment discrimination law is particularly well-documented, compliance-based liability systems that not only mirror, but in some cases are explicitly modeled after, the OSGs pervade liability and damage inquiries in environmental, tort, health care, corporate, and securities law, among others. (Rather than boring Conglomerate readers with a long list of citations here, let me just suggest to Miriam that if she wants sources on these points to drop me a line or call me and I’m happy to help).

These compliance-based liability regimes pose the same dangers identified by Baer in the criminal context. For example, as is the case in the corporate criminal system, entity-level mitigation rules in the civil system are overly vague and crafted by those who lack the requisite information and incentives to set compliance and cooperation at efficient levels. In both the civil and criminal contexts, firms ha