November 29, 2003
Bainbridge on Good Faith
Posted by Gordon Smith

Steve Bainbridge has written in response to my post on the Fiduciary Duty of Good Faith. Simply stated, Steve's post is brilliant! If you are interested in understanding this development in Delaware corporate law, check it out.

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The Fairchild Eight
Posted by Gordon Smith

Can you name the Fairchild Eight? Here they are: Julius Blank, Victor Grinich, Jean Hoerni, Eugene Kleiner, Jay Last, Gordon Moore, Robert Noyce, Sheldon Roberts. The leader, according to Arthur Rock, was Eugene Kleiner, who went on to become an initial investor in Intel (founded, of course, by Gordon Moore and Robert Noyce) and to found the most visible venture capital firm in Silicon Valley. Gene Kleiner died last week. He led an amazing life.

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Living Tables
Posted by Gordon Smith

Kids used to worry about monsters under their beds. This story about linked kitchen tables gives this fear new meaning:

The tables are in separate physical locations, and each table comes with a radio frequency identification tag reader. The readers can detect the presence on the table of cups, saucers, cigarette packs and other objects marked with RFID tags. Each table can also display images using a projection powered by a Mac or Linux computer located underneath the table.

The two-way system ... sends images of those tagged objects back and forth between the tables through the Internet, providing participants with a pictorial record of their partners' activities. When someone places a coffee cup on one table, for example, an image of a cup automatically appears on the display on the partner's table.

OK, it's cool that you can do that, but I'll pass.

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November 28, 2003
Public Works in IT
Posted by Gordon Smith

Last week I praised Utah for deciding to construct a fiber-optic data network connecting 17 Utah cities. Arnold Kling didn't take me to task, but he denounced Larry Lessig for writing a similar -- though admittedly more thoughful -- piece in the most recent issue of Wired, praising Burlington, Vermont for deciding to build an advanced fiber network.

Kling scores some important points, with which I am sympathetic. His main point is that people who do not use the network should not be required to foot the bill. He also writes:

My guess is that what we will learn is that companies with good political connections will get the contracts to build these AFN's. They'll be like baseball stadiums – a great way for private interests to suck up taxpayer money and claim that it's for civic benefit.

Lessig, by contrast, relies heavily on Cornell economist Alan McAdams, arguing:

AFNs are natural monopolies.... Most economists would leap from the premise of a natural monopoly to the conclusion that such a monopoly must be regulated. But regulation is not the end that McAdams seeks. Ownership is. If a traditional network provider owned an AFN in a particular area, that network provider, acting rationally, would charge customers a monopoly price, or restrict service to get its monopoly benefit. But if the customer owned the network, then the customer could get the same access at a much lower price and be free of use restrictions. McAdams is pushing -- and Burlington and other cities are actually deploying -- customer-owned AFNs.


The sticking point, however, comes whenever governments get involved. And no doubt, this is skepticism with good reason. But city council members are not stringing AFNs; nor is fiber being manufactured in local communes. Instead, global firms such as Black & Veatch string the fiber and set up the networks. These companies don't own the networks they build, any more than highway contractors own the highways they build. Yet because they operate in a competitive market, the service they provide is efficiently priced. They build the networks that the customer owns, and the customer escapes the burden of a monopolist network provider. The key is ownership, and the different incentives that ownership creates.

I question Lessig's last point about the competitive market for contractors leading to efficient pricing of AFNs. The big constraint here is not the market for contractors, but the market for cities or regions, which are competing for customers (people and businesses) as vigorously as commercial enterprises. In today's mobile society, the market will reward cities that navigate these waters most effectively.

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November 27, 2003
New Blogs in My Blogroll
Posted by Gordon Smith

Just crawling around the Web on this Thanksgiving night, and I found a few new blogs that might be of interest to people who visit here.

* Ensight, by Jeremy Wright, a designer. Great aesthetic, interesting entries. Jeremy has a wonderful anti-spam resource page. Check it out if you are having problems with spammers. And who isn't?

* Chris Shipley's blog feels more like a column in a good news magazine than a daily journal. Perhaps that's because it is just that -- a series of essays on technology and business from an experienced journalist. Don't expect lots of entries, but plan to stay awhile when you visit.

* Marginal Revolution has been on my radar screen for a little while, but I was really moved by Tyler Cowen's Thanksgiving Day message. Well done!

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Buy Something Day
Posted by Gordon Smith

Dan Gillmor is plugging "Buy Nothing Day," an annual pushback against consumerism. The designated date is the day after Thanksgiving -- the largest shopping day of the year. I'm not buying ...

The campaign, that is. While one slice of the message appeals to me -- excessive attention on material things is harmful to self and community -- the campaign as a whole strikes me as incredibly narcissistic and wrong-headed. "Buy Nothing Day" is sponsored by Adbusters Media Foundation, which describes itself as

a global network of artists, activists, writers, pranksters, students, educators and entrepreneurs who want to advance the new social activist movement of the information age. Our aim is to topple existing power structures and forge a major shift in the way we will live in the 21st century.

So what are these "existing power structures" that are so threatening? The Foundation's website is not specific on this, relying on a vague sense of discontent towards globalization to attract followers. Some possible culprits appear in an entertaining set of spoofads, most of which are aimed at firms that didn't exist 50 years ago, like McDonald's and Gap. Perhaps this should be a lesson to the Adbusters: if you really want to turn the world upside down, get a new idea (not a refried notion of "revolution" borrowed from your parents' generation) and run with it! That's what Ray Kroc did. Ditto Bill Gates and Sam Walton and Tommy Hilfinger. You may not like what these folks created, but that would be missing the point.

The Foundation claims that "millions of participants around the world" go an a consumer fast on Buy Nothing Day. Yeah, right. As I read that, my wife and daughter were a few feet away, planning their annual assault on local department stores. The assault begins at 5:30 am and lasts until mid-morning, when the shopping warriors return, weary but triumphant! Mostly, they will buy new clothes for our growing family, and like most people, they will spend well within their means. This scene will be replicated by millions of people across the United States tomorrow, and, on balance, it is good.

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November 26, 2003
The Fiduciary Duty of Good Faith
Posted by Gordon Smith

The so-called "fiduciary duty of good faith" is hot. In the last couple of months, I have received two working papers from professors who are trying to explain the Delaware Court of Chancery's opinion in the Disney litigation. In addition, a student on the Wisconsin Law Review has asked for my help on a note with regard to that case. Then this morning, I spent over an hour with another student who wanted to write a class paper on good faith. This is a tough issue, but I think I have it figured out. So listen closely; I'm only going to say this once.

You are probably familiar with the facts that led to the Disney litigation. After losing number-two-man Frank Wells to a helicopter crash and two other senior executives -- Jeffrey Katzenberg and Richard Frank -- to other corporations, Disney CEO Michael Eisner hired Michael Ovitz to become the second-in-command. Ovitz's employment agreement was approved by Disney's compensatoin committee, which had hired Graef Crystal for (worthless) advice. To make a long story short, neither the committee nor Crystal ever computed the amount that Disney would be required to pay Ovitz in the event of a non-fault termination. When Ovitz left the company 14 months later pursuant to a non-fault termination agreement, he took with him a severance package with about $140 million. Understandably, shareholders were upset. Some of them sued.

In the first round of litigation, the Delaware Supreme Court affirmed the Chancery Court's dismissal of the compaint -- which the Court called a "blunderbuss of a mostly conclusory pleading" -- but allowed the plaintiff to file an amended complaint with respect to the waste claim. Brehm v. Eisner, 746 A.2d 244 (Del. 2000). A claim for waste describes, in simplest terms, "'an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration." Glazer v. Zapata Corp., Del.Ch., 658 A.2d 176, 183 (1993).

If ever the facts supported a claim of waste, this was the case, and the Delaware Supreme Court was unable to bring itself to dismiss the claim without giving the plaintiffs another bite at the apple. Importantly, the Court also obliterated the notion of "substantive due care":

As for the plaintiffs' contention that the directors failed to exercise "substantive due care," we should note that such a concept is foreign to the business judgment rule. Courts do not measure, weigh or quantify directors' judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only. Irrationality is the outer limit of the business judgment rule. Irrationality may be the functional equivalent of the waste test or it may tend to show that the decision is not made in good faith, which is a key ingredient of the business judgment rule.

This passage is crucial to understanding what subsequently happened to the doctrine of good faith in Delaware. Although the Court does not like the phrasing, "substantive due care," the idea underlying that notion remains intact. In the future, we are told, litigants and courts should call it "waste" or "bad faith."

When the case returned to the Court of Chancery, therefore, the "fiduciary duty of good faith" became the focus and was equated with something akin to irrationality. Chanceller Chandler described a board that had made no attempt at all to fulfill its obligations. (One might say that the directors acted irrationally in the sense that their failure to act could not be explained.) In Chandler's own words:

These facts, if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation. Instead, the facts alleged in the new complaint suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a "we don't care about the risks" attitude concerning a material corporate decision. Knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company. Put differently, all of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule.

And thus we see that the new formulation of the fiduciary duty of good faith is nothing new at all, but simply a reinvigoration of substantive due care. I say "reinvigoration" because substantive due care has long been considered a moribund doctrine, but this new duty of good faith could have legs. At a minimum, we see a dramatic change in the tone of the Court of Chancery, which had until this case treated the fiduciary duty of good faith with some disdain. See, e.g., Emerald Partners v. Berlin (Del. Ch. 2001) ("Although corporate directors are unquestionably obligated to act in good faith, doctrinally that obligation does not exist separate and apart from the fiduciary duty of loyalty. Rather, it is a subset or 'subsidiary requirement' that is subsumed within the duty of loyalty, as distinguished from being a compartmentally distinct fiduciary duty of equal dignity with the two bedrock fiduciary duties of loyalty and due care.").

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November 25, 2003
Thoughts on the Carnival
Posted by Gordon Smith

Finally, I was able to look at the other entries in this week's Carnival of the Capitalists. (I have been running on fumes lately and definitely looking forward to a Thanksgiving Break!) Here are a few favorites (even when I didn't agree, they got me thinking):

* Jim Berkowitz's e-journal: he talks about an article that describes the process of establishing trust relationships in marketing. The content of the article is not directly applicable to anything I do, but it's close. I am interested in the idea of trust in relationship formation, which was a really hot topic in law a few years ago. My interest stems from a new project on relational contracts, and trust is a big part of the picture. One idea underlying the project is that all contracts are incomplete, and trust helps to fill the gaps. Perhaps that is pretty obvious, but it is worth making explicit.

* Todd Bucksten of A Penny For ... wrote a post on game theory and product pricing. Todd, help me out here, because I don't see the analogy to game theory. Is product pricing really a prisoner's dilemma? Your description of the prisoner's dilemma (quoted from Principia Cybernetica Web) states, "The dilemma resides in the fact that each prisoner has a choice between only two options, but cannot make a good decision without knowing what the other one will do." A prisoner cannot take back his cooperation, but companies can observe each other and adjust their behavior accordingly. I am no expert on game theory (is that obvious yet?), but it does not seem to fit.

* Torsten Jacobi at TJ's Weblog has another interesting post on pricing. The message here is that companies are trying to create a more scientific approach to pricing and getting VC money to do it. TJ is a bit of a skeptic and concludes, "pricing technology is really an amazing combination of math and gut feeling combined with technology."

* If VentureBlog is right about product adoption, here's what we have to look forward to: "the consumer electronics business to look more and more like the movie business. Bigger budgets, more upfront marketing, wide distribution and quick deaths to things that just don't seem to be getting traction." Wow!

* Last but far from least, I always enjoy reading Professor Bainbridge. This week his post is a thorough dissection of Alex Tabarrok's post The Mutual Fund Scandal - much ado about nothing at The Marginal Revolution.

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November 24, 2003
Carnival of the Capitalists #7 is Available
Posted by Gordon Smith

Truck and Barter is hosting. This is the first time I have entered, and I received some good traffic from it. Here was my entry.

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November 23, 2003
Posted by Gordon Smith

This one is relatively close to home. In Sparta, Wisconsin, a group of monks has formed a business selling discount printer supplies. LaserMonks thrives on free labor (what else is monk going to do when he isn't chanting or praying -- watch the Packers?). Here is the come-on line from their website: "Yes, we really ARE monks! We really DO pray and help others. Hundreds of years ago, monks survived by baking bread, making wine, or copying manuscripts. We survive by selling Ink and Toner Supplies online, at HUGE discounts.....and YOU benefit!" If you want to see some of their press clippings, check USA Today, Wired, or Forbes.

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The Truth About Profits
Posted by Gordon Smith

Rob the BusinessPundit has discovered an eternal truth: "the profits belong to those who take the risk, not those who do the work." He is starting a new company, and he argues that his employees aren't taking a risk: "If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash. So from this perspective, who should the profits go to if there are any?" Of course, this is overly simplistic in that employees are taking a risk, too, when they join a startup firm. Moreover, what is stopping Rob from simply moving to another firm if this one fails? Nothing, really, but that isn't what concerns him. What concerns him is the burden of ownership. In examining this burden a little closer, we gain more insights about how profits are allocated.

Taking a cue from "Why Not?", let's try flipping this. Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control.

So, sign me up for some residual control!

Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.

Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.

Viewed this way, risk is a natural consequence of the need to link profits to control. It becomes effect rather than cause.

UPDATE: I wrote this last night (early this morning?) and failed to mention that I am not attempting to tell the story from the entrepreneur's point of view. That story would go something like this:

Entrepreneur discovers an opportunity that she wants to exploit and forms a firm to do just that. The firm needs employees, suppliers, investors, etc. As they divvy up the claims against the firm, the entrepreneur sells the fixed claims first. This is partly because the entrepreneur wants to retain the residual claim (because it has the most upside) and partly because the other participants generally do not want the residual claim (can you imagine an employee agreeing to pay the owner first, then taking whatever is left over?). This leaves the entrepreneur in control and holding the residual claim, which is the riskiest claim. Make sense?

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November 22, 2003
Business Blogs
Posted by Gordon Smith

When businesses first started using blogs to develop and nurture consumer communities, I was a skeptic. Most business blogs seemed too careful or too "not spontaneous." For the most part, I like reading blogs that are a bit edgy, though with a point. More recently, however, I have discovered that business blogs can actually be kind of fun.

For example, web design firm 37 signals has a popular blog called Signal vs. Noise. Also, I am not really into packaging for Latino appeal, but ¿Ask Mariví? is a well-done blog. Or how about rexblog, which focuses on the magazine industry. Even really mundane businesses can maintain a nice blog. How about Northfield Construction Company -- not one I am likely to visit repeatedly, but I would if I lived in Northfield.

If you are thinking about starting a business blog, check this out.

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Why Not?
Posted by Gordon Smith

People have long struggled to teach creativity and innovation. I think Barry Nalebuff and Ian Ayres have hit upon a method that is really fun and useful in their book Why Not? How to Use Everyday Ingenuity to Solve Problems Big and Small.

The approach is animated by four questions:

What Would Croesus Do? Imagining how a consumer with unlimited resources (a modern-day Croesus) would solve a problem can inspire practical solutions. For example, Donald Trump or Bill Gates dont spend much time waiting on hold. They have an assistant wait on hold and then buzz them when the call goes through. Of course, we cant all afford personal assistants. Is there any way the rest of us could emulate this “personal assistant” strategy? Instead of waiting on hold to speak with an airline customer representative, why not have the airline call you back (just like Gatess assistant) when the rep is ready to talk to you? With caller ID, you wouldnt even have to enter your number.

Why Don’t You Feel My Pain? Externalizing internal problems, forcing the cost of inefficient practices to the surface is another way to solve problems. For example, the cost of providing auto-insurance is based on how many miles people drive. But the price doesnt reflect mileage. Why not pay-per-mile auto insurance? Why not have telemarketers pay us to listen to their pitches? While they are trying to sell you a product, you can be selling them your time.

Where Else Would It Work? This translation tool starts with a solution from another context and searches for a problem it might solve somewhere else. Why not translate ski area season passes to movie theaters? Why not take the airplane version of R-rated movies and make them available on DVDs? The April 15th deadline for contributions to an IRA is what leads to the idea of extending the tax deadline for charitable contributions.

Would Flipping It Work? Looking for potential symmetry and then turning things around offers unexpected solutions. built a business by flipping the way prices are set; they have customers offering prices to airlines. Heinz and Hunts stimulated sales by turning their ketchup bottles upside down. Having customers rewind video tapes at the beginning of the rental prevents people from shirking. Spain eliminated its waiting list for organs by changing the default from opt-in to opt-out. Instead of a boycott against companies that do things wrong, why not a buycott for companies that do things right.

Also, check out their cool website.

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November 21, 2003
Corporate Governance & Market Efficiency
Posted by Gordon Smith

When the Internet bubble popped in 2001, some legal scholars heard an explosion while others heard an annoying hiss. Prior to the 1990s, financial economists spoke of market efficiency in the same way an electrician might describe a toggle switch: it’s either on or off. Markets are either “efficient” or “inefficient.” What that usually meant, when describing capital markets, was either that securities prices incorporated all publicly available information about the issuing company (“efficient”) or they did not (“inefficient”).

More recent economic scholarship has taken a more nuanced view of market efficiency. Instead of a toggle switch, most financial economists liken market efficiency to a dimmer switch, with varying degrees of brightness depending on one’s faith in market institutions. Under this view, the issue is not whether a market is efficient, but whether the market is efficient enough.

This difference in view between toggle switches and dimmer switches has important implications for debates about corporate governance. During the 1980s, corporate governance scholars were preoccupied with the implications of the efficient markets on governance law and practice. For most of that decade, efficient markets was treated as more than a hypothesis. In the oft-quoted words of Michael Jensen, “there is no other proposition in economics which has more empirical evidence supporting it.” Embracing this view, many legal scholars relied heavily on efficient markets to do the work of corporate governance, particularly through hostile takeovers.

Recent research is less sanguine on the ability of markets to perform the tasks necessary to a well-functioning corporate governance system. This research suggests two propositions on which financial economists could likely reach broad consensus: (1) irrational investors have the ability to push prices around; (2) these deviations from fundamental value are either trivial in size or impossible to detect, thus limiting arbitrage opportunities for rational investors. In other words, markets might be “efficient” in the sense that rational investors will not be able to consistently beat the market, even while prices generated by those efficient markets deviate from fundamental values.

The implications for corporate governance are clear: markets need help. Recent reforms by Congress and the SEC have been much criticized, but the general inclination is right. Corporate governance cannot run on the fuel of efficient markets alone.

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Posted by Gordon Smith is great fun. Jim Gordon from BYU (perhaps the funniest law professor alive) alerted the Contracts listserv of the existence of 17 people named "Hadley V. Baxendale." Now, the listserv is a beehive of activity, as people try to locate other people with goofy, law-related names. Here are some suggestions for how to use the site for more serious pursuits. By the way, has been a publicly traded company since early 2000. While it's stock has followed general market trends, it has had a lower downside. With all of these law professors now on the site, however, business is looking good!

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