Conglomerate Blog: Business, Law, Economics & Society

January 30, 2015

The Ethical Slide, Train Tickets, and Helping the Next Generation of Corporate Leaders to Choose Differently

Posted by Josephine Sandler Nelson

It has been a pleasure to guest-blog for the last two weeks here at the Glom. (Previous posts available here: one, two, three, four, five, six, seven, eight, and nine.) This final post will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes and to support the teaching of ethics in business schools.

Sometimes bad ethical behavior is simply the result of making obviously poor decisions. Consider the very human case of Jonathan Burrows, the former managing director at Blackrock Assets group. Burrows’s two mansions outside London were worth over $6 million U.S., but he ducked paying a little over $22 U.S. in train fare each way to the City for five years. Perhaps Burrows had calculated that being fined would be less expensive than the inconvenience of complying with the train fare rules. Unluckily, the size of his $67,200 U.S total repayment caught the eye of Britain’s Financial Conduct Authority, which banned Burrows from the country’s financial industry for life. That’s how we know about his story.

But how do small bad ethical choices snowball into large-scale frauds? How do we go from dishonesty about a $22 train ticket to a $22 trillion loss in the financial crisis? We know that, once they cross their thresholds for misconduct, individuals find it easier and easier to justify misconduct that adds up and can become more serious. And we know that there is a problem with the incentive structure within organizations that allows larger crises to happen. How do we reach the next generation of corporate leaders to help them make different decisions?

Business schools still largely fail to teach about ethics and legal duties. In fact, research finds “a negative relationship between the resources schools possess and the presence of a required ethics course.” Moreover, psychological studies demonstrate that the teaching of economics without a strong ethical component contributes to a “culture of greed.” Too often business-school cases, especially about entrepreneurs, venerate the individual who bends or breaks the rules for competitive advantage as long as the profit and loss numbers work out. And we fail to talk enough about the positive aspects of being ethical in the workplace. The situation is so bad that Luigi Zingales of the University of Chicago asks point-blank if business schools incubate criminals.

New business-school accreditation guidelines adopted in April 2013 will put specific pressure on schools to describe how they address business ethics. Because business schools are accredited in staggered five-year cycles, every business school that is a member of the international accreditation agency will have to adopt ethics in its curriculum sometime over the next few years.

We hope that the work outlined in my blogposts, discussed at greater length in my articles, and laid out in our proposed book will be at the forefront of this trend to discuss business ethics and the law. We welcome those reading this blog to be a part of the development of this curriculum for our next generation of business leaders.

January 28, 2015

The Intracorporate Conspiracy Doctrine and CEO Turnover

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, six, and seven) discussed why conspiracy prosecutions were the best method to penalize coordinated wrongdoing by agents within an organization. Using alternative doctrines to impose liability on behavior that would otherwise be recognized as an intracorporate conspiracy results in flawed incentives and disproportionate awards.

The fundamental problem with substituting responsible corporate officer doctrine and control person liability for reforming the intracorporate conspiracy doctrine is that these alternative doctrines represent exactly what Professor Martin objects to: actual imposition of blind “respondeat superior” liability. For example, under these doctrines, “in most federal courts, it is not necessary to show that the corporate official being charged had a culpable state of mind.” Instead, the issue before the court is merely whether the officer had control and responsibility for the alleged actions. Accordingly, it is not a defense to control person liability that the officer did not “knowingly participate in or independently commit a violation of the Act.”

But simply penalizing the officer who is in the wrong place at the wrong time does little to define and encourage best practices. Moreover, with these and other explosive hazards for corporate service, it should be no surprise that top executives are demanding and receiving ever-increasing compensation for often short-term positions. Since 2009, the year that the NSP case establishing “control person” liability was settled, the discrepancy in pay between top management and the average worker has been growing dramatically. In 2013, the CEO of J.C. Penny Co., for example, was exposed for making 1,795 times what the average U.S. department store employee made. From 2009 to 2013, as measured across Standard & Poor’s 500 Index (S&P 500) of companies, “the average multiple of CEO compensation to that of rank-and-file workers” has risen to 204, an increase of twenty percent.

It is true that the financial crisis did reduce executive compensation packages before 2009, and that there has been a historical trend towards the growth of executives’ salaries as a multiple of average workers’ salaries. For example, “[es]timates by academics and trade-union groups put the number at 20-to-1 in the 1950s, rising to 42-to-1 in 1980 and 120-to-1 by 2000.” But the jump in executives’ salaries from 2009 has been extraordinary. The new emphasis on vicarious liability for individuals under the responsible corporate officer doctrine since that date must be considered part of executives’ demands for such high compensation in exchange for their risky positions.

The average duration of a CEO’s time in office has diminished as well. In 2000, the average tenure of a departing S&P 500 CEO in the U.S. was ten years. By 2010, it was down to eight years. In 2011, merely a year later, the average tenure of a Fortune 500 CEO was barely 4.6 years. In 2013, that former CEO of J.C. Penny Co. served for only eighteen months.

With an eighteen-month tenure, how much can the chief executive of a large company discover about the wrongdoing that his or her new company is committing? Furthermore, how much can that person design and institute good preventative measures to guide his or her subordinates to avoid that harm? A blindly revolving door for CEOs does not help those interested in effectively reducing the wrongdoing of agents within the corporation. Incentives without intracorporate conspiracy immunity would be different because they would reward the agent who abandons a conspiracy. (More about this argument here, here, here, and here.)

My next blogpost will examine how substituting alternative doctrines for prosecuting intracorporate conspiracy affects incentives under Director’s and Officer’s (D&O) liability insurance.

January 27, 2015

Frustration with the Intracorporate Conspiracy Doctrine Distorts Other Areas of Law

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, and six) discussed why conspiracy prosecutions should be used to reach coordinated wrongdoing by agents within an organization. The intracorporate conspiracy doctrine has distorted agency law and inappropriately handicaps the ability of tort and criminal law to regulate the behavior of organizations and their agents.

My Intracorporate Conspiracy Trap article argues that the intracorporate conspiracy doctrine is not properly based in agency law, and that it should most certainly not be applied throughout tort law and criminal law. As a result of the immunity granted by the doctrine, harmful behavior is ordered and performed without consequences, and the victims of the behavior suffer without appropriate remedy. My Corporate Conspiracy Vacuum article argues that public and judicial frustration with the lack of accountability for corporate conspiracy has now warped the doctrines around it.

Courts have used a wide variety of doctrines to hold agents of enterprises responsible for their actions that should have prosecuted as intracorporate conspiracy. Some of these doctrines include:

• piercing the corporate veil,

• responsible corporate officer doctrine, and related control person liability,

• denying the retroactive imposition of the corporate veil, and

• reverse piercing of the corporate veil.

But the new applications of these alternative doctrines are producing distortions that make the doctrines less stable, less predictable, and less able to signal proper incentives to individuals within organizations.

An example of how piercing the corporate veil has been used to defeat intracorporate conspiracy immunity can be seen in the Morelia case. A previous blogpost discussed how the intracorporate conspiracy doctrine has defanged RICO prosecutions of agents and business entities. In Morelia, which was a civil RICO case, the federal district court, obviously outraged by defendants’ behavior in the case, explicitly permitted plaintiffs to pierce the corporate veil to avoid application of the intracorporate conspiracy doctrine. In a creative twist invented from whole cloth to link the two doctrines, the Morelia court overruled its magistrate judge’s recommendation to announce:

"Since the court has determined that plaintiffs have properly alleged that the corporate veil should be pierced, the individual defendants may be liable for corporate actions and any distinction created by the intra-corporate doctrine does not exist."

Regarding its test for piercing the corporate veil, the Morelia court further overruled its magistrate’s recommendation by focusing on plaintiffs’ arguments regarding undercapitalization, and its decision included only a single footnote about the disregard of corporate formalities.

The Morelia court is not alone in its frustration with the intracorporate conspiracy doctrine and in its attempt to link analysis under the intracorporate conspiracy doctrine with the stronger equitable tenets of piercing the corporate veil. More subtly, courts across the country have started to entangle the two doctrines’ requirements as intracorporate conspiracy immunity has become stronger and courts have increasingly had to rely on piercing the corporate veil as an ill-fitting alternative to permit conspiracy claims to proceed. Even large public companies should take note. No public company has ever been pierced, but a bankruptcy court recently reverse-pierced corporate veils of the Roman Catholic Church, which is far from a single-person “sham” corporation. My Corporate Conspiracy Vacuum article discusses additional examples and repercussions for incentives under each of these alternative doctrines.

My next blogpost will examine how frustration with intracorporate conspiracy immunity has led to volatility in responsible corporate officer doctrine and related control person liability. Ironically, executive immunity from conspiracy charges fuels counterproductive CEO turnover.

January 26, 2015

The Silenced Connecticut Sex-Abuse Case

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, and five) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within an organization. The 2012 prosecution of Monsignor Lynn for twelve years of transferring predator priests from parish to parish at the command and for the benefit of the Archdiocese of Philadelphia was defeated by the intracorporate conspiracy doctrine. Moreover, this was not the first time that the Roman Catholic Church had used the doctrine to help its bureaucrats escape liability for suppressing sex abuse cases.

In 1997, employees of the Roman Catholic Church in Connecticut were alleged—very much like Lynn—to have covered up the sexual misconduct of a priest, enabling him to continue to abuse children entrusted to the Church’s care by virtue of his office. When sued for civil conspiracy by the victims, the employees’ defense was that they were acting in the best interest of the corporation.

The Connecticut court found that the test for whether an agent is acting within the scope of his duties “is not the wrongful nature of the conspirators’ action but whether the wrongful conduct was performed within the scope of the conspirators’ official duties.” If the wrongful conduct was performed within the scope of the conspirators’ official duties, the effect of applying the intracorporate conspiracy doctrine is to find that there was no conspiracy. Because covering up the priest’s sex abuse was in the best interest of the corporate organization, the court found that the employees were all acting on behalf of the corporation. The court never reached the issue of whether the employees’ actions rose to the level of a civil conspiracy. Under the intracorporate conspiracy doctrine, it was a tautology that no conspiracy could be possible.

This case is interesting not only because it documents the way that the intracorporate conspiracy doctrine protects enterprises from inquiry into conspiracies, but also because of the subsequent history of its allegations. The full extent of the Bridgeport Diocese’s wrongdoings—if current public knowledge is indeed complete—only came to light in December 2009, twelve years after the 1997 case. It took twelve years, the combined resources of four major newspapers, an act displaying public condemnation of the Roman Catholic Church by members of the state legislature, and finally a decision by the U.S. Supreme Court to release the documents that could have become the basis of the intracorporate conspiracy claim in 1997. There is still no conspiracy suit or any criminal charge against the Diocese. Additional details about the case are available in my article The Intracorporate Conspiracy Trap. The article will be published soon in the Cardozo Law Review, and it is available in draft form here.

Astonishingly, none of the extensive news coverage about the sexual abuse cases in Bridgeport over those additional twelve years has connected these facts to the original 1997 case defeated by application of the intracorporate conspiracy doctrine. If the intracorporate conspiracy doctrine had not provided immunity, the case might have revealed the Diocese’s pattern of wrongdoing long beforehand and in a much more efficient way.

My next blogpost reveals additional dangers from the spread of the intracorporate conspiracy doctrine: frustration with the intracorporate conspiracy doctrine has started to distort other areas of law.

January 23, 2015

How We Should Have Tried Monsignor Lynn

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, and four) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within a business organization. The same legal analysis applies to religious organizations.

We should have been able to charge Monsignor Lynn and the Archdiocese of Philadelphia that directed his actions to hide the sexual abuse by priests with criminal conspiracy. Instead, Pennsylvania charged Lynn with two things: child endangerment and conspiracy with the priests.

As international news outlets later reported, Lynn could not be guilty of child endangerment because the state’s statute could not apply to an administrative church official who did not directly supervise children.

Lynn could not be guilty of conspiracy with the priests because he did not share their “particular criminal intent.” As the jury understood, Lynn was not trying to help a predator priest get from parish to parish so that “he can continue to enjoy what he likes to do.” Lynn was trying to protect the reputation of his employer, the Archdiocese—if the priests benefitted, that was a side issue.

So why didn’t the prosecution charge Lynn and the Archdiocese with conspiracy? It was the Archdiocese that directly coordinated and profited from Lynn’s actions. The intracorporate conspiracy doctrine, as discussed before, would bar that prosecution. In Pennsylvania, it is “well-settled that a corporation cannot conspire with its subsidiary, its agents, or its employees.”

Finally, considering other options, Lynn could not have been charged with possible crimes such as obstruction of justice. Lynn was too good: Lynn and the Archdiocese were so successful at covering up the sexual abuse and silencing victims, there was no ongoing investigation to obstruct. “Aiding and abetting” the Archdiocese’s cover-up of the sex abuse would have been difficult to pursue (see more here) and is not allowed under RICO in the Third Circuit.

My next blogpost will demonstrate that the Monsignor Lynn case was also part of a pattern by the Roman Catholic Church in America to use the intracorporate conspiracy doctrine to hide the coordinated wrongdoing of its agents to cover-up sexual abuse by priests. Fifteen years before prosecutors attempted to try Monsignor Lynn, the silenced Connecticut sex-abuse case showed the Church how effective this defense could be.

January 22, 2015

Sex Abuse, Priests, and Corporate Conspiracy

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, and three) introduced the topic of how the intracorporate conspiracy doctrine prevents the prosecution of coordinated wrongdoing by individuals within organizations. This post illustrates the doctrine’s effect in the context of a specific organization—here a religious one: the Roman Catholic Archdiocese of Philadelphia and the systematic transfer of predator priests. This post is based on my article The Intracorporate Conspiracy Trap to be published soon in the Cardozo Law Review. The article is available in draft form here.

For twelve years, from 1992 to 2004, as Secretary for Clergy, Monsignor William Lynn’s job within the Philadelphia Archdiocese was to supervise priests, including the investigation of sex-abuse claims. In 1994, Monsignor Lynn compiled a list of thirty-five “predator” priests within the archdiocese. He compiled the list from secret church files containing hundreds of child sex-abuse complaints. On the stand, Lynn testified that he hoped that the list would help his superiors to address the growing sex-abuse crisis within the Archdiocese. But for twelve years Lynn merely re-assigned suspected priests, and he hid the abuse within the church. His superiors never acted on the list that Lynn gave them—in fact, they ordered all copies of the list destroyed—and Lynn never contacted outside authorities. As late as 2012, one of the “predator” priests on Lynn’s list was still serving in a parish.

All parties agree that Lynn’s actions in transferring priests who molested children allowed those priests to continue to abuse children, sheltered the priests from potential prosecution, and directly protected the Philadelphia Archdiocese’s reputation.

In fact, Lynn’s actions had been ordered by the archbishop on behalf of the Archdiocese. Lynn reported what he was doing to his superiors, who rewarded Lynn with twelve years of employment and a prominent position within the Archdiocese for doing his job as they saw it. Moreover, the archbishop himself inadvertently revealed the existence of the number thirty-five “predator” priests to the media, and he was the one who ordered all copies of the list to be shredded to keep it from being discovered in legal proceedings.

The instinct here is that this behavior—the transferring of predator priests to cover-up the sexual abuse of children—should have been illegal for Monsignor Lynn to pursue. But the Commonwealth could not prosecute Monsignor Lynn and the Archdiocese for conspiracy. Furthermore, immunity for Lynn’s behavior is now the rule in most state and federal jurisdictions around the country. As described in an earlier blogpost, the intracorporate conspiracy doctrine provides immunity to an enterprise and its agents from conspiracy prosecution, based on the legal fiction that an enterprise and its agents are a single actor incapable of the meeting of two minds to form a conspiracy.

My next blogpost will further investigate why this behavior was not illegal under our current system, and how we should have tried Monsignor Lynn.

January 20, 2015

Corporate Conspiracy Charges for the Financial Crisis

Posted by Josephine Sandler Nelson

In my previous blogpost, I granted the merit of defense counsel’s argument that the actions of discrete individual defendants—when the law is not permitted to consider the coordination of those actions—may not satisfy the elements of a prosecutable crime.

But what is the coordination of individuals for a wrongful common purpose? That’s a conspiracy. And, for exactly the reasons that defense counsel articulates, these types of crimes cannot be reached by other forms of prosecution. The U.S. Supreme Court has recognized that conspiracy is its own animal. “[C]ollective criminal agreement—partnership in crime—presents a greater potential threat to the public than individual delicts.” When we consider the degree of coordination necessary to create the financial crisis, we are not talking about a single-defendant mugging in a back alley—we are talking about at least the multi-defendant sophistication of a bank robbery.

Conspiracy prosecutions for the financial crisis have some other important features. First, the statute of limitations would run from the last action of a member of the group, not the first action as would be typical of other prosecutions. This means that many crimes from the financial crisis could still be prosecuted (answering Judge Rakoff’s concern). Second, until whistle-blower protections are improved to the point that employees with conscientious objections to processes can be heard, traditional conspiracy law provides an affirmative defense to individuals who renounce the group conspiracy. By contrast, the lesson Wall Street seems to have learned from the J.P. Morgan case is not to allow employees to put objections into writing. Third, counter to objections that conspiracy prosecutions may be too similar to vicarious liability, prosecutors would have to prove that each member of the conspiracy did share the same common intent to commit wrongdoing. The employee shaking his head “no” while saying yes would not be a willing participant, but many other bankers were freely motivated by profit at the expense of client interest to cooperate with a bank’s program.

My next blogpost will ask: where are the prosecutions for corporate conspiracy?

J.P. Morgan’s Witness and the Holes in Corporate Criminal Law

Posted by Josephine Sandler Nelson

It is a pleasure to be guest-blogging here at The Glom for the next two weeks. My name is Josephine Nelson, and I am an advisor for the Center for Entrepreneurial Studies at Stanford’s business school. Coming from a business school, I focus on practical applications at the intersection of corporate law and criminal law. I am interested in how legal rules affect ethical decisions within business organizations. Many thanks to Dave Zaring, Gordon Smith, and the other members of The Glom for allowing me to share some work that I have been doing. For easy reading, my posts will deliberately be short and cumulative.

In this blogpost, I raise the question of what is broken in our system of rules and enforcement that allows employees within business organizations to escape prosecution for ethical misconduct.

Public frustration with the ability of white-collar criminals to escape prosecution has been boiling over. Judge Rakoff of the S.D.N.Y. penned an unusual public op-ed in which he objected that “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.” Professor Garett’s new book documents that, between 2001 and 2012, the U.S. Department of Justice (DOJ) failed to charge any individuals at all for crimes in sixty-five percent of the 255 cases it prosecuted.

Meanwhile, the typical debate over why white-collar criminals are treated so differently than other criminal suspects misses an important dimension to this problem. Yes, the law should provide more support for whistle-blowers. Yes, we should put more resources towards regulation. But also, white-collar defense counsel makes an excellent point that there were no convictions of bankers in the financial crisis for good reason: Prosecutors have been under public pressure to bring cases against executives, but those executives must have individually committed crimes that rise to the level of a triable case.

And why don’t the actions of executives at Bank of America, Citigroup, and J.P. Morgan meet the definition of triable crimes? Let’s look at Alayne Fleischmann’s experience at J.P. Morgan. Fleischmann is the so-called “$9 Billion Witness,” the woman whose testimony was so incriminating that J.P. Morgan paid one of the largest fines in U.S. history to keep her from talking. Fleischmann, a former quality-control officer, describes a process of intimidation to approve poor-quality loans within the bank that included an “edict against e-mails, the sabotaging of the diligence process,… bullying, [and] written warnings that were ignored.” At one point, the pressure from superiors became so ridiculous that a diligence officer caved to a sales executive to approve a batch of loans while shaking his head “no” even while saying yes.

None of those actions in the workplace sounds good, but are they triable crimes??? The selling of mislabeled securities is a crime, but notice how many steps a single person would have to take to reach that standard. Could a prosecutor prove that a single manager had mislabeled those securities, bundled them together, and resold them? Management at the bank delegated onto other people elements of what would have to be proven for a crime to have taken place. So, although cumulatively a crime took place, it may be true that no single executive at the bank committed a triable crime.

How should the incentives have been different? My next blogpost will suggest the return of a traditional solution to penalizing coordinated crimes: conspiracy prosecutions for the financial crisis.

October 13, 2014

The Marmon Group: A Mini-Berkshire?

Posted by Usha Rodrigues

As I blogged a few days ago, I've been reading Larry Cunningham's Berkshire Beyond Buffett: The Enduring Value of Values. The thesis is that Berkshire Hathaway's value will endure beyond its founder, Warren Buffett, because of the larger values of the organization. After making his case he argues (like a good lawyer) that a precedent and analogous case already exists: the Pritzger's Marmon Group.

You know you're a corporate law geek if the mere mention of the Marmon Group made you sit up and take notice. The Marmon Group plays a role in 2 classic corporate law stories. Larry mentions one: every student of corporate law should remember the Marmon Group as the bidder in the infamous corporate law case Smith v. Van Gorkom. If you don't remember the 1985 Delaware Supreme Court case, you didn't have me as a Corporations professor. Spoiler alert: the directors are found to have breached their fiduciary duty and are thus personally liable for potentially millions of dollars in damages.

What many casebooks omit--but not Klein, Ramseyer, Bainbridge, which I am happily using this term--is that the case settled for $23 million. $10 million came from D&O insurance, and "almost $11 million came from the Pritzkers." The Pritzkers had no legal duty to pay for the directors' settlement--but they did it because they felt it was the right thing to do.

The Marmon Group's second corporate law claim to fame is as a player in Barbarians at the Gate, thhe father of corporate tick-tocks. The Marmon Group backed one of the bidders, the First Boston Group. There's this great scene where in a second round of the auction they need to raise more money. First Boston makes a 45-minute presentation to a British sugar company, S& W Berisford, on a Saturday night. First Boston hoped that Berisford could make a decision by Tuesday. 20 minutes later, the company committed $125 million.

One of First Boston's advisors asks "Do these people have any idea what they're doing?... I mean, they're going to commit $125 million. Why should they do it."

Handelsman stared at Finn as if it was the silliest question he'd ever heard. "Jay [Pritzker] asked them to."

The common theme from these two stories? Sophisticated businesspeople regularly act for motivations other than money. Again and again in Berkshire Beyond Buffett, either Berkshire itself or one of its subsidiaries demonstrates that money is not ultimately what drives them. Most notably, many of Berkshire's current subsidiaries turned down higher offers from other acquirers because they valued the reputation for hands-off management that Berkshire promises.

Here's a concrete example I used with my Corporations class when discussing conflicting interest transactions. One of Berkshire's subsidiaries was operated by a devout Mormon whose stores were closed on Sundays. He wanted to expand out of the state, but Buffett was skeptical. He thought the model could work in highly religious Utah, but not beyond. Here is Cunningham quoting Buffett:

Bill then insisted on a truly extraordinary proposition: He would personally buy the land and build the store--for about $9 million as it turned out--and would sell it to us at his cost if it proved to be successful. On the other hand, if sales fell short of his expectations, we could exit the business without paying Bill a cent.

The store was "an instant success", and Berkshire wrote the Bill a $9 million check. Bill refused to take a penny of interest. It's a good example of insider transactions that benefit the firm. It also suggests Larry might actually be right about Bershire's staying power. I can't help thinking there is a lot of value in offering businessmen like this the combination of liquidity and autonomy Berkshire provides, insulating them from the demands of Wall Street.

October 06, 2014

Book Review: Berkshire Beyond Buffet

Posted by Usha Rodrigues

GW Law professor Larry Cunningham has a new book coming out, Berkshire Beyond Buffett: The Enduring Value of Values. Two caveats before I begin my review. First, I received a review copy for free. Second, we own shares of Berkshire Hathaway. Don't get excited, people, I'm not rolling in Class A. My husband likes to dabble in stock picking with a little "fun money, and" right out of college, one of the first stocks he bought was Berkshire Class B.

When talk over the dinnertable turns to investments, we've often speculated as to how much our shares will drop in value with the death of Warren Buffett--who is now 84. Cunningham's thesis is that it should not drop much at all, because there is much more to Berkshire Hathaway than the Oracle of Omaha. So I was definitely interested to start this book.

A word about organization: The challenge of organizing a coherent story around a conglomerate is large, composed of 50 subsidiaries. Larry says that the teacher in him organized the traits at issue as a mnemonic spelling out "Berkshire":

Budget-conscious
Earnest
Reputation
Kinship
Self-starters
Hands Off
Investor Savvy
Rudimentary
Eternal

This framing seemed a little forced to me at times. But I understand its motivation: trying to make sense of commonalities among the the many diverse businesses that comprise Berkshire Hathaway.

My takeaway was this: as I tell my students, successful entrepreneurs face two choices for exit: sale and IPO. If you sell, you lose your autonomy. If you go public, Wall Street expects certain returns and will punish you for failing to deliver.

What if you have a family business and are pretty happy with the way things are, but are worried about looming tax problems when the founder dies? Berkshire Hathaway offers the right kind of firm a third path, one that allows the founders to cash out and yet keep the business running as a BH subsidiary just as it had been independently. Nothing is free, of course, and companies regularly accept a BH bid which is less than competing bids, because they know that they will be able to run the company as they choose. But these select firms use the freedom, shelter from the market, and capital that Berkshire provides to flourish.

I was particularly interested to see the book's account of David L. Sokol's departure from the firm. Sokol, a senior Berkshire exec, bought $10 million in shares in the Lubrizol Corporation and then recommended the company as an acquisition target to Buffett. Cunningham, while obviously a Buffett fan, did not sugarcoat his account of Berkshire's initial missteps in handling what burgeoned into a scandal. Although the SEC failed to prosecute Sokol (which he claimed as vindication), the larger point Cunningham underscores is that Berkshire Hathaway's reputation is its chief asset.

I'll have more to say about that in another post. For now, I'll conclude by saying that this was a timely and accessible book, chock-full of insights and enjoyable to read.

September 03, 2014

Autonomy At Berkshire Hathaway, A Guest Post From Larry Cunningham

Posted by David Zaring

Larry's book on Berkshire Beyond Buffett is due in a month, and we'll be reading it on the Glom. Here's a taste, prepared by Larry, and if you follow the link, you can see a full chapter of the book.

Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect the balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers were chosen because of their excellence and are urged to act on that excellence.

Berkshire defers as much as possible to subsidiary chief executives on operational matters with scarcely any central supervision. All quotidian decisions would qualify: GEICO’s advertising budget and underwriting standards; loan terms at Clayton Homes and environmental quality of Benjamin Moore paints; the product mix and pricing at Johns Manville, the furniture stores and jewelry shops. The same applies to decisions about hiring, merchandising, inventory, and receivables management, whether Acme Brick, Garan, or The Pampered Chef. Berkshire’s deference extends to subsidiary decisions on succession to senior positions, including chief executive officer, as seen in such cases as Dairy Queen and Justin Brands.

Munger has said Berkshire’s oversight is just short of abdication. In a wild example, Lou Vincenti, the chief executive at Berkshire’s Wesco Financial subsidiary since its acquisition in 1973, ran the company for several years while suffering from Alzheimer’s disease—without Buffett or Munger aware of the condition. “We loved him so much,” Munger said, “that even after we found out, we kept him in his job until the week that he went off to the Alzheimer’s home. He liked coming in, and he wasn’t doing us any harm.” The two lightened a grim situation, quipping that they wished to have more subsidiaries so earnest and reputable that they could be managed by people with such debilitating medical conditions.

There are obvious exceptions to Berkshire’s tenet of autonomy. Large capital expenditures—or the chance of that—lead reinsurance executives to run outsize policies and risks by headquarters. Berkshire intervenes in extraordinary circumstances, for example, the costly deterioration in underwriting standards at Gen Re and threatened repudiation of a Berkshire commitment to distributors at Benjamin Moore. Mandatory or not, Berkshire was involved in R. C. Willey’s expansion outside of Utah and rightly asserts itself in costly capital allocation decisions like those concerning purchasing aviation simulators at FlightSafety or increasing the size of the core fleet at NetJets.

Ironically, gains from Berkshire’s hands-off management are highlighted by an occasion when Buffett made an exception. Buffett persuaded GEICO managers to launch a credit card business for its policyholders. Buffett hatched the idea after puzzling for years to imagine an additional product to offer its millions of loyal car insurance customers. GEICO’s management warned Buffett against the move, expressing concern that the likely result would be to get a high volume of business from its least creditworthy customers and little from its most reliable ones. By 2009, GEICO had lost more than $6 million in the credit card business and took another $44 million hit when it sold the portfolio of receivables at a discount to face value. The costly venture would not have been pursued had Berkshire stuck to its autonomy principle.

The more important—and more difficult—question is the price of autonomy. Buffett has explained Berkshire’s preference for autonomy and assessment of the related costs:

We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that [disagreeable] operating and capital decisions are occasionally made. . . . Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly—or not at all—because of a stifling bureaucracy.

Berkshire’s approach is so unusual that the occasional crises that result provoke public debate about which is better in corporate culture: Berkshire’s model of autonomy-and-trust or the more common approach of command-and-control. Few episodes have been more wrenching and instructive for Berkshire culture than when David L. Sokol, an esteemed senior executive with his hand in many Berkshire subsidiaries, was suspected of insider trading in an acquisition candidate’s stock.

(The above is an excerpt from Chapter 8, Autonomy, from Lawrence Cunningham’s upcoming book, Berkshire Beyond Buffett: The Enduring Value of Values; the full text of the chapter, which considers the case for Berkshire’s distinctive trust-based model of corporate governance, can be downloaded free here.)

[To read the full chapter, which can be downloaded for free, click here and hit download]

August 29, 2014

Are the Reports of the Cupcake Craze Death Greatly Exagerated?

Posted by Lisa Fairfax

Last month when Crumbs, America's first public cupcake company, announced it was closing most of its stores after its stock was delisted by Nasdaq, and it had defaluted on some $14.3 million in financing, many viewed the annoucement as a sign that the cupcake industry bubble had finally burst.

In the past decade, cupcakes appeared as if they were taking over with businesses sprouting up everywhere. Not only had cupcakes come to replace traditional cakes at weddings and birthday parties, but people were willing to stand in ridiculously long lines and pay sometimes as much as $5 for a single cupcake or between $30 and $50 for a dozen. A 2012 story on Georgetown Cupcakes in DC suggested that sometimes the lines could take up to an hour to get through.

Some view the apparent demise of Crumbs as a sign that the cupcake craze was a trend that had finally run its course. Or put differently, an unsustainable business model. In addition to concerns about potential market saturation and over exposure, some indicated that pricing was a problem. Indeed, while cupcakes were touted as an "affordable luxury," some note that at $3.50-$6 each, cupcakes seemed more like an overpriced snack. As this article suggests, these cupcakes were not something middle America could afford. Another problem was low cost of entry--potentially reflected in the many people who thought they could give the cupcake business a try. Still another was diversity--could an industry based on a single food really survive with competitors that offered more than just cupcakes? And then there was the problem of potentially swimming against the health trend. Cupcakes seem like a healthier option than your large slice of cake or pie, but alas as a Forbes article points out "your typical large frosted premium cupcake can have as much as 500 calories," and lots of people eat more than just one.

Of course others note that the demise of Crumbs may reflect issues unique to Crumbs. Indeed, there are some cupcake businesses that continue to thrive.

And even the Crumbs story is not over. Just this week it was annouced that Crumbs would begin reopening it stores because, as the Wall Street Journal notes, a court signed off on a sale of Crumbs to "self-styled turnaround guru Marcus Lemonis and Dippin Dots owner Fischer Enterprises." Apparently, part of the turnaround strategy will be moving away from reliance on just cupcakes and incorporating other desserts.

So while the cupcake bubble has certainly gotten smaller, it may be too soon to tell if we can really call the cupcake craze a bust.

June 09, 2014

Uber Skepticism

Posted by Usha Rodrigues

Gordon recently blogged about Uber's sky-high valuation. I'm skeptical for 2 reasons. First, regulation could put Uber out of business fast (I'm lookin at you, airbnb). Allied against it are taxicabs and limousine services, and these folks have a lot of money to lobby in state capitols. I'm not saying that the Forces of Technological Disruption are doomed, but my current research is making me much more cynical about money's influence on politics--and that's saying something. I do think Uber is playing it smart by getting big fast--the path for regulatory survival will be to be so widespread that it becomes normal. If everyone has an aunt or college grad or cousin who's an Uber driver, then regulating it out of existence seems downright unamerican.

My second reason for skepticism people's tendency to mistake their world for the whole world. Call it Bobo Blinders. Uber is big in places where venture capitalists flourish: New York, Northern Cali, Chicago. I see a scenario where venture investors use this service, all their friends and family, everyone they know uses this service, and they think: This is going to be huge! Everyone will use this service!

We'll see.

June 07, 2014

Uber

Posted by Gordon Smith

Uber just raised $1.2 billion at a valuation of $18 billion.

Let that sink in for a moment: a valuation of $18 billion! If that doesn't look like much, you must be thinking about Facebook's pre-IPO valuation of $50 billion, but Uber just landed the second largest private valuation on record. See here.

I have used Uber's service only once, with Vic Fleischer and Christine Hurt in Seattle, and I spent the whole ride quizzing the driver on the business model. Of course, I could have just googled it, but it was nice to see the business through the driver's eyes. It looks a lot like franchising, but with lower investment costs for the franchisees (drivers).

Why all the fuss? This is not just about replacing taxis. This is about displacing UPS and FedEx. See here for more on that possibility. Exciting stuff.

P.S. For those of you invested in the SharesPost 100 Fund, congratulations! Uber is on the list.

June 06, 2014

NBA showdown with Donald Sterling as Contracts Case Study

Posted by Erik Gerding

The ugly Donald Sterling episode seems to be moving to resolution with a pending sale of the L.A. Clippers to Steve Ballmer. The sordid story makes for a great case study in a Contracts course, not least because of the wealth of material that is publicly available, particularly one of the central contacts – the NBA “Constitution and Bylaws.” Often the key contracts in the most notorious disputes are kept confidential, with only snippets of the agreements available even via court dockets.

Under the terms of the Constitution and Bylaws, the NBA Commissioner position that Sterling could be forced to sell his team was strong but not (pardon the pun) a slam dunk (see Michael McCann’s early analysis here and an analysis of Sterling’s response here).

The Commissioner and Sterling each were aiming to persuade a motley group of NBA owners, who may have been concerned with, among other things, the outrage of players and fans towards Sterling, the damage to their league of having Sterling continue as owner, and the precedent of forcing an owner to sell.

Layered on top of this were the family law and tax considerations of Sterling transferring ownership whether to his estranged wife or to a buyer.

In the end, economics pushed Sterling to sell. He was faced with a stark choice of trying to hang on to an asset that was damaged goods just by remaining in his hands versus over a billion dollar profit from selling.

In teaching this episode, students should be cautioned against jumping immediately to the “of course he will sell” conclusion. The hard work of analyzing the contracts helps explain the negotiating positions of the NBA commissioner, the various NBA owners, Sterling, and his wife as they bargained in the shadow of the law. The contractual language also will help prepare for any post-sale litigation;Sterling has already initiated one suit and threatened more . Sterling's wife apparently agreed to indemnify the NBA against legal challenges by her husband, which adds yet another teaching wrinkle. One puzzle for students: what was the strategy behind declaring Sterling incompetent?

Too bad I am not teaching Contracts in the fall.