Distinguished Jurist Lecture: Hon. Richard A. Posner, "The Embattled Corporation"

welcome I would like to welcome you all to this year’s institute in law and economics distinguished jurist lecture as I’m sure all of you in this room know the institute of law and economics which is a joint institute between the law school and the wharton school is really a shining example of both the interdisciplinary strengths and spirit of the University of Pennsylvania it was originally founded in the 1970s and it now runs really an extraordinary range of innovative programs including labor and corporate roundtables the joint law and finance departments lectures the law and entrepreneurship lectures a variety of wonderful academic conferences the list goes on and on the distinguished jurist lecture is typically one of the highlights of the school year and that certainly holds true today as we welcome this year’s speaker Seventh Circuit Judge Richard a Posner this is the second time Judge Posner has delivered the distinguished jurist lecture he is the first recidivist lecture in the two decades of this series there is a very simple reason Judge Posner is an epic figure he’s not only one of the most influential judges in the country he’s one of the most influential academics and thinkers over the last 30 years colleagues have called him a brilliant heretic and awesome intellect and a man who was quote refuted more conceptual errors than st. Augustine as we also all know he was first known as the guiding light of the lawn economics movement when he began his career as an academic it was thought radical to apply the principles of economics to law but that was before Judge Posner legitimized the new interdisciplinary field with the publication of his now classic text economic analysis of law the book was bold and prescient erudite and exhaustive much like the author who has been rattling cages ever since as a public intellectual who serves debate with his never-ending stream of ideas today Judge Posner is a zap to draw on nici’s Creed of self-determination and read the classics in Greek as he is did a claim about problems with intelligence reforms in the wake of 9-11 independent and unpredictable judge posner takes issue with judicial activists and strict constructionists he is in short a strikingly original thinker but I hasten to add not an original list judge Posner’s extraordinary eclecticism owes in part to his broad experience his life divides into two chapters academia and jurisprudence but they actually merge into one after graduating at the top of his class from Harvard Law School where he was president of the Law Review Judge Posner was a clerk for Justice William Brennan he remained in Washington to serve in the Kennedy and Johnson administration’s and then embarked on his storied academic career at the University of Chicago Law School where it was a professor from 1969 through 1981 today Judge Posner remains a senior lecturer at Chicago Law School it is in this free market intellectual environment that Judge Posner hones his economic worldview arguing in books and articles that the law ought to bend to economic efficiency and the production of wealth it is also where he founded the Journal of legal studies which looks at theoretical and empirical research on law and legal institutions from an interdisciplinary perspective in 1981 President Reagan appointed judge posner to the US Court of Appeals for the Second servant Circuit Seventh Circuit and he served as chief judge from nineteen ninety three to two thousand judge Posner’s career on the bench has been in many respects an extension of his academic engagements his well-crafted opinions read like literature elegant and broad a disciple of judge learned at hand Judge Posner is a pragmatist with a libertarian streak famously expressed in his words your rights end where his nose begins in establishing this anvil record he’s published more opinions than any judge of his era on average over 75 a year nearly three times the national norm his opinions are cited far more than any other sitting judge and four times more than the average federal judge not surprisingly he’s also been called quote the preeminent judicial theorist of our time but that is only one part of his

public portfolio as his night job Judge Posner has also become a truly extraordinary public scholar and intellectual exploring with erudition virtually every single topic of contemporary importance in this role he has published some 38 books on everything under the Sun from the economics of criminal law sexuality and old age the law and literature any trust law and intellectual property it would be foolish for me or anyone else to attempt to capture the full breadth and originality of this Renaissance intellect in an introduction it can’t be done if Judge Posner did not exist says one pundit it would be hard to believe he could suffice it to say that in all of his writings he employs a pro Matic creative yet provocative approach in the process he illuminates what one person is called the blind spots and the phony affirmations of our standard professional understandings seemingly no subject escapes judge Posner’s gaze as judge Pierre Laval puts it he writes books faster than I can read them his life and times would make us fitting subject for a long book and of course stretch potion will probably write that book over one of these weekends he’s also received essentially every major award in honor the Academy confers including honorary degrees from major leading academic institutions including this one it’s not surprising that his full body work has been rightfully called the richest since Oliver Wendell Holmes in today’s lecture Judge Posner turns his attention to the embattled corporation I can assure you I can assure you that his insights will be thoughtful pragmatic and provocative please join me in welcoming a brilliant Jarvis a recidivist scholar before this group and a seminal voice in the law and economics movement the Honorable Richard Posner thank you very much the infest place BTW you know they’re only two types of introduction in the first the introducer / praises the speaker raising expectations which was shattered as soon as the speech begins in the second the introducer by his wit and vividness articulate miss I shows that really you’ve got the no roles reverse this is the person you came to listen to so Dean Fitz is actually managed to combine both of those modes his introduction so quickly trying to lower your expectations maybe be pleasantly surprised the origin of this talk is in the fact that I’ve been updating my textbook treatise economic analysis of law it’s only revised a few years ago the sixth edition was published in 2003 it’s a little early to be revised it but the publisher wanted me to and in the course of revision when I came to my chapters on corporations and financial markets I realized it in a significant part they had been obsoleted by the events of the last few years both events in the real world and events in in scholarship and that’s so I’ve been led to rethink some of the things I’ve said in the book and I’m going to share my rethinking with you today I’m going to focus on CEO compensation but at the end I’ll say a few words about securities regulation I want to start with just a brief sketch of the the theory of the firm very very brief and emphasize that it’s really it’s the control problem that defines the firm and limits its its size if you’re ever curious why there’s more than one firm in the economy the reason isn’t diminishing returns which just limit the amount of a given product that a firm can efficiently produce what limits the size of the firm is that the span of supervision of a single person is limited and that means the more employees a firm has the more supervisors it has to have and the more supervisor has to have the more supervisors of supervisors it has to have because just as first-line supervisors span of control is limited so as you go up the tears of the hierarchy each supervisory official can

supervise only a small group of supervisors below him so as the hierarchy lengthens out to your tier upon tier you get delay in executing orders loss of information information garbled attenuation of the directions emanating from the top so coherence diminishes and eventually overwhelms whatever advantages there were two having a large organization moreover the larger the organization larger and more complex the more difficult it will be to correlate the work of a particular employee with the value of the organization’s output and that will make it difficult to align the employees incentives without of the of that of the firm and with that that lack of alignment employees will have greater scope to engage in activities that benefit themselves but not not the firm that’s the problem that economists discuss under the rubric of agency costs to have a principal and agent principal would likely agent to do exactly what the principal wants but the agent has own interests and to the extent that the control by the principal is is in perfect the agent may be able to stray from the principles of directions now if you look at the economy as a whole you see that economic activity is coordinated by a combination of the market and other voluntary arm’s length transactions sometimes not arm’s length sometimes family friendship altruism and so on but also of course by organizations you have both the macro order which is the market and the micro order of the individual organizations within the market and it used to seem too many people that since organizations are about organizing the optimal way of organizing entire market would be to have a central planner who would tell everybody what to do and Friedrich Hayek famously argued in the collapse of communism showed that this this didn’t work that it is very difficult actually to pull through organization the knowledge that all the members of the economic community have a manager of a complex system simply will not know everything that he needs to know in order to optimize the organization’s activities and so you need decentralized methods of coordination in particularly the market in which price becomes the signal the kind of embodiment of what each individual market knows so price is the mechanism by which a private information is diffused throughout the market and ultimately throughout the entire economy so you lack that signaling device when you’re inside an organization there you substitute directions for negotiations guided by price and that brings me to this to the issue of compensation since you’re not buying the output of an individual employee within within the firm you you have to figure out you know what is what is output is worth in order to know what to what to pay him well in the simplest economic model of compensation a worker right up to the level of a CEO of a giant corporation is paid as marginal product which is essentially his contribution to the firm’s net income but if you look at the actual compensation structures of a firm that firms they deviate from that you observe that wages a very across employees of the same rank and same job classification by much less than the difference in their contribution to the company this is regardless of whether they’re unionized workers and you also observes that observed that employees who do satisfactory work can’t expect to have regular annual wage increases a regardless of whether their contribution to the firm is actually increasing eventually as the worker gets near retirement his or her contribution to the firm may actually be declining and yet the worker will still expect annual

increases or certainly no decreases if you think about these anomalies they can be explained as horizontal wage compression may simply reflect the difficulty of measuring individual contributions to output special when people are working in teams and the trick is to keep the teams small enough that the members can observe each other and if they’re shirking by one of them can report it to to a supervisor and an interesting device that one observes throughout the economy and in universities and elsewhere is that even if you even if you can’t actually evaluate the contribution that individual members of a team make to to the team’s production often it’s obvious who is the best person right so you may not be able to rank them may not be able to attach a money value the contribution of each but you may be able to spot the the star and that’s the basis of a promotion system and pick out a person who is best and promote that person and give them a higher salary in that way you create incentives for outstanding performance and you kind of allied the lack of knowledge you have about specific contribution to the bottom line of an individual worker and as far as the second phenomena is kind of vertical wage drift this may be designs are to match income with consumption over the life cycle and it may also deal with what economists call the last period problem that as a person gets up toward retirement age his incentive to work hard for the firm and so on diminishes he knows he’s not going to be promoted anymore he’s not going to be doesn’t have to make a good impression on his bosses so companies employers have all sort of yer of their last period workers and one way to keep them in line is you know give them give them their keep giving them higher wages every year and then at the end you know give them some generous pension benefits so so we can we can tinker with the the actual observed compensation patterns in firms to try to make them fit the basic model of compensation and we can’t actually companies can actually pay each worker marginal product but but you can explain the deviations and discuss substitutes that companies use such as promotion well but can this standard model of compensation even refined his fashion cannot explain the compensation of corporate CEOs I’m skeptical about that so American CEOs are paid about twice as much on average as their counterparts in other countries and yet this is not because Americans at all levels earn more than their foreign counterparts the difference between average US and foreign wages is much smaller below the CEO and other senior management level sort of the proximate cause of this difference is that American CEO incomes contain a much higher fraction of non salary income bonuses and in particular stock options these methods of some irregular methods of compensation particular stock options have a degree of an uncertainty associated with them and that creates risk we know that most people are risk averse and we know that actually corporate executives have a particular reason to be risk-averse which is a lot of their human capital is tied up in the particular company they’d be worth much less working elsewhere so they want to lose their jobs and so they will they will they want to see their incomes bouncing up and down too much so they have to be compensated for bearing risk so if much of their income is in risky form such as stock options options they will demand a higher wage but the adjustment that would be necessary to compensate them is much less than the difference between their incomes and out of their foreign counterparts a more persuasive explanation with the difference is that a stock ownership tends to be more concentrated in foreign

countries than in the United States and the fewer shareholders there are in a company the more incentive each of them or group has to monitor the compensation of the people actually running the company and this in France supported by the fact that the stock option we think about is not not really a very tailored way of motivating chief executive officers to to do their best because a lot of things affect the price of stock other than the efforts of the CEO so to tie a CEOs income to his to the to the value of his company’s stock but little like if the president United States salary the president you knighted States was tied to GNP now as we think that if stock options really aren’t that great and incentive device well why do they feature so prominently in the incomes of our CEOs and one reason may be that the these options unlike the the income the value of the options unlike the the salary that’s paid to a corporate executive doesn’t have to be reported as a corporate expense even though it really is now the security analysts and the large stockholders who do monitor the performance of executives they they can figure out what these options are likely to cost the company and you’d think that the the knowledge they obtain would diffuse throughout the market so that it would the fact that it wasn’t reported on an accounting statement as an expense wouldn’t make any difference to the value of the company but I’m going to be discussing evidence that the capital markets are not as efficient as some of us used to think and therefore failures of disclosure even though rather rather superficial in the sense that the knowledge is out there somewhere may may in fact affect stock prices when you look at the incentive of a board of a board of directors to rein in a CEO compensation that is is weak the board of directors in general as a control device is has actually many of the same weaknesses as congressional committees as oversight for executive for the executive branch of government the directors are part-timers their incentives to vigorously police executive salaries are weak and the boards tend to be dominated by by other CEOs and it’s just natural both psychologically and and economically for someone who is a highly paid CEO to think that the CEO of the company on whose board he sits should also be a highly paid so I’ve presented some reasons for thinking that American CEOs may actually on average be overcompensate in terms of the actual value of their contribution to the firm but there’s been a major challenge to this kind of skeptical thinking in a recent paper not not published yet but important paper by Xavier Quebec go by and Agustin lon da and what they say is simply that the the high very high incomes of American CEOs and the growth of those incomes in recent decades reflects nothing more than the fact that the market value of their firms is very great and growing and this very simple argument actually returns us to the simple marginal product theory of worker payment the idea simply the chief executive of a more valuable firm if he can increase the value of that firm by some percentage the absolute increase in the firm’s value will be greater the more more valuable the firm is so there are two equally skilled managers one manager is a grocery store and the other managers IBM the latter is probably creating greater value right one percent increase in the value of IBM much more than one percent increase in the value of the grocery store but there is an

alternative explanation for this correlation between market values and CEO compensation which is simply that the more valuable the the firm is in particular the more rapidly it’s the growth of its market value the easier it is to hide the compensation of the chief executives and so this sort of complementary to the notion of stock options as way of hiding the cost to firms of their CEOs so suppose a ten percent firm’s value increases by ten percent and the board of directors increases the CEO salary by 3% the percentage of the firm’s value that is going to the CEO will decrease because the market is growing by larger percentage than his income and so so the percentage of the firm’s value that goes to pay at CEO will actually be diminishing but it’s increasing for him of course and it may be increasing beyond anything that a market in CEOs would would would demand and here maybe a partial explanation of this curious phenomenon that a corporate mergers so often fail to increase the value of the acquiring firm increases its size but not its value but you can see how from the CEO standpoint the larger the enterprise you control the larger income you can appropriate without its becoming such a large fraction of the total income of the corporation that shareholders directors and so on begin to object there is one more theory of executive compensation very interesting want to want to mention very briefly and this says that the key managerial skill in the modern American corporation is not the ability to run a company well it’s the ability to use public relations skills and accounting leisure demand to create a bubble in the corporation stock and the argument is the the more the corporation’s stock is worth the more the CEO can jack up the value of the stock the lower the cost of the corporation of acquiring additional capital either by acquiring other firms or by issuing new shares and also the lower the cost of attracting good executives if this analysis is correct as merit then it is efficient to base a CEOs compensation on the performance of the corporation stock rather than on the company’s fundamentals such as its profits and revenues and costs but it’s probably efficient in a private rather than a social sense right these bubbles burst eventually so the gains are temporary and they really switch wealth around among companies rather than producing aggregate gains and wealth those you could only get by better management now the concern with excessive CEO compensation is at one end of a spectrum of criticism of corporations the other end of which of course is occupied by these high-profile criminal prosecutions and convictions of senior managers of major corporation and you you you’re familiar I’m sure with these and with this our bits are Bonnie’s Oxley Act of 2002 as a as a reaction and what is interesting from perspective of my talk today is how many of the recurrent types of misbehavior of which corporate managers are accused this is not all criminal by any means but most of these is a recurrent types of misbehavior relate quite directly the issue of a CEO compensation so they include well what I mentioned already the failure to treat the value of stock options as a corporate liability which is kind of concealment of incomes of high level of management the failure to disclose in the company’s financial statements the cost of non-pecuniary benefits to officers and clean retired officers such as use of company aircraft and residences and the sort of thing that came out in the in the jack welch

divorce remember preceding the flowers the basketball tickets all these strange perks a third failure to disclose loans by corporations to their officers are the subsequent forgiveness of the loans and again a kind of concealment inadequate supervision of management by boards of directors including inadequate policing of overly generous compensation packages lately we have the backdating of stock options in order to enable them to to be to be cashed not clear how whether this is particularly a device used to benefit the highest level of corporate executives but again it’s it’s part of the the boy or it triggers that the concern with a stock option as a as a device another is that their complaints that stock options cause managers to try to manipulate short-term fluctuations and the value of their stock to make sure that the options have value there there are of course a number of other abuses that are that are charged which not directly related to the corporate compensation those special special entities in the in the Enron case and the you know preferential allocation of IPO shares to people who can steer underwriting business the investment bank and so on but but but clearly compensation related abuses is a is a big part of the of the picture now one basic question that economists always want to ask about wealth transfers is whether these really represent social costs or mere rearrangements of the of the of the pie you just slicing the pie differently maybe creating greater inequality of wealth or you making the pie smaller by imposing real costs probably most of the effect of the over compensation of CEOs would be a wealth effect a wealth transfer from shareholders to executives but there are probably real costs as well what economists say is if you have if you have very if you have no lucrative opportunities you will ration aaliyah costs in order to be able to exploit that opportunity you will invest in in trying to get that pot of gold that’s what’s called rent-seeking so rent-seeking or costs that result from my desire for for wealth and in the case of this obsessive CEO compensation you can have a cost of various sort of which probably the most important is that to the extent that corporate earnings are reduced even even modestly because of deflection or you know reallocation of wealth from shareholders common stocks become less attractive forms of investment and investors shift to other forms which may be socially more socially less productive but become more attractive as corporations are are looted now corporation law has has long been alert to the concern about the appropriation of the Corporations income by its executives and you know they’re all sorts of devices that are used all kinds of accounting requirements of course the board of directors elected by the shareholders and there are many private methods by which market tries to control these abuses analysts and brokerage firms and and the like but these turn

out to be highly imperfect controls and you know I’ve mentioned the limitations on what a board of directors can can do the role of the auditor is one of a built-in conflict of interest where the where the corporation pays the auditor that’s both to monitor its its behavior so the people hiring the order there are the people whom the auditor is supposed to be watching now the auditors have profession on legal obligations but there is a kind of inherent conflict of interest and one way Tsar Bonnie’s Oxley tries to deal with this is by severing the by saying that the firms are not to buy consulting services from the auditors it’s hard to see that as a important control because if auditors somehow are in a position to sell favorable audits to their clients they can sell in the form of high auditing fee is rather than some combination of auditing fees and consulting fees although there may be some element of concealment if they can do the latter now we used to think that any of these abuses resulting from weaknesses in the sort of internal disciplinary structure of a corporation would be cancelled by competition in the product market that the other firms that we’re wasting resources on you know excessively paid ceos would be losing losing sales to their competitors and losing investors to other investment opportunities but if you have a market dominated by large firms and if as I think this problem of control within a corporation is is something that afflicts every large organization then you’ll find all the firms in the market and essentially the same position all of them having to incur this significant agency costs because of their size and complexity and then corporation will have no tendency to eliminate that costs a what can be done about this very unclear I mentioned what seemed to me like an idol tour largely idle gesture by Congress and sorry bodies Oxley Act and limiting you know hiring your auditor to do consulting as well you know even before that of course Arthur Andersen had split its auditing from its consulting split them in two separate companies which is the tendency because actually auditing and consulting or such different activities that it’s extremely awkward to place them in in the same firm there is a thesis in organizational economics that you don’t want to have incompatible cultures within the same organization because it will be very difficult to establish incentive schemes compensation so on that will make people in each of the different cultures are comfortable with being in that firm in fact if you have two tracks in a firm and one is is the more attractive whatever reason your best people will go into that and you are the other the other track will tend to wither better to have it split off in a separate firm which can develop its own and optimize its incentive and control mechanisms to the particular characteristics of its of its work and the and of course we’ve seen from all the prosecution’s most of which are under you know laws the law as it existed before sarbanes-oxley that our standard fraud laws are able to cope with the the egregious forms of corporate misconduct the ones that aren’t egregious probably can’t be dealt with effectively by law at all well what is um the perhaps most important factor in my rethinking about the the problem of control within the corporation is the

challenge to the efficient markets theory of of capital markets by a behavioral finance in the my previous editions of my book I defend a very strong form of the efficient market theory one implication of which is that investors should focus on diversification rather than on try to time market turns or pick stocks because tactics like that reduce diversification increase transaction costs and don’t generate any positive even gross return let alone net return because of the information circulates so quickly and accurately in the market that you really can’t beat it I still I think the efficient market theory is I think I think most economists agree it still retains substantial explanatory value it’s guided important legal reforms which I continue to thank our sound such as what’s really revolutionary reform of trust investment law over the past 30 years that has allowed trustees to adopt the kind of passive strategy that the efficient market theory commends where you buy a choir e diversified portfolio of securities but the only trading you do you know less you need cash something that joy is the training necessary to maintain diversification in that way you you eliminate all diversify Bowl risk and that that diverse file of risk is not compensated and therefore you’re ahead of the game and you save the transaction costs of the kind of futile effort to beat the market now everyone recognized even in this of the heyday of the efficient market theory on unchallenged as yet by behavioral finance that there was a lot of irrationality and ignorance in in the market they were there you know traders who traded on noise and the people who created these strange head and shoulder patterns you know the technical traders they seemed nuts but it was assumed that that these deviations from rationality were random and if they were random they wouldn’t affect the average price of securities they just be a little a little bit of noise and even if they were systematic rather than random deviations that was thought that their bad effects would be undone by by arbitrageurs so arbitrage you know is a form of speculation that takes the point look for two very similar things that are selling for different prices when they should be selling for the same price or at least this spread should be smaller and buy you know and if you recognize that this is not an equilibrium that that something’s wrong with this spread it’s too big then you can make money and also you can eliminate and by your efforts you eliminate the disequilibrium example is how arbitrageurs exploit price discrimination you have a firm that’s selling at a high price to consumers that you know believed to have a low elasticity of demand and a low price the same product to sumers have high elasticity of demand the arbitrator may buy from the low elasticity sellers and as are the high elasticity sellers that the low price resell it to the people who are paying a high price make money doing that buying cheap selling selling dear the same product but at the same time gradually erasing the difference bringing the market back to equilibrium well the way this works in securities market again you have suppose two stocks minutes of companies which seemed you know really identical terms of expected returns and risk and so on but they’re selling a very different prices and you suspect that that’s an irrational difference so if you if you sell one of these short and by the longer one and and you’re you know confident that these really are our

clothes substitutes you will you know probably be able to make money with a relatively low low risk so if you short you sell short the one you think is going to drop you’re buying the other one the substitute if you’re right and it drops well you you you make money on that and it’s true that this yeah the price of the other one may be rising to meet it or may open no I’m sorry the other one may be falling as well but if the other one was by hypothesis undervalued relative to the one you’re selling short then it won’t fall as much as the first so so arbitrage arbitrage involves a hedging it’s speculation it’s hedge speculation and it ought to be a profitable way of eliminating any systematic deviations from rationality in the market well what the behavioral behavioral finance people like andrei shleifer very very distinguished economist who has written extensively on this and a lot of research on without what they they have shown two things that are that are damaging to the efficient market theory first thing they shown is that these irrationality ‘he’s tend in fact to be rather than accidents you know mean a few idiots in the market they have to do with with cognitive defects that virtually all people suffer from or at least so many people suffer from it that it has real effects on the securities market so for example you know people have what’s called loss aversion which means they’re more reluctant to sell losing stocks than winning stocks even though in an efficient mark at any moment in time a stock whatever the price is that prices are the best estimate of the value of the stock doesn’t matter what’s going down or going up but if it’s going down be more likely to hold on and the hope that will go up if it go up there more likely to sell it and take their profits that’s irrational behavior but it’s so common that it affects the behavior of the market they are thought to demand an excessive premium for holding stocks rather than bonds because stocks have more downside risk than bonds and this loss aversion that I just mentioned implies that downside risk law is what people are particularly upset about they don’t feel it’s fully compensated by the upside risk which comes from holding stocks because their risk your investments a very serious problem is that people have great difficulty thinking in probabilities terrible difficulty and one things they don’t understand is that runs you know having the same flip a coin and you flip you know four heads in a row and you think that that’s a pattern actually it’s just an accident and so people see patterns where they don’t exist and this is why they say to give irrationally a rational way to the short run performance of stocks and the short run performance of money managers so if they think a money manager so if they observe money manager has made money three years running they think great that’s a pattern that’s likely to continue whereas it’s probably just a matter of luck now in the earlier analysis one might have you one might have said well this is fine but the arbitrator’s will take care of this but it turns out that arbitrage doesn’t doesn’t work as well as as it used to be thought and the reason is that arbitrage remember arbitrage is a way of involves hedging as well as speculation if you lose the hedging feature of it becomes extremely risky and because when it’s very risky then there aren’t that many barbra treasurers they keep getting broke go going broke and so on but but now we think that that the hedging often doesn’t work because very often turns out there there aren’t these two stocks that are really good substitutes for each other that have the identical returns and so on the market may regard

them you know irrationally as as very different and their insistence on the difference between these stocks may persist beyond the interval in which you can sustain a short selling campaign got getting wiped out now the extent of these deviations from rationality that are due to or that have been exposed by behavioral finance the extent of the deviation significance is it is debated and the remedies are very very difficult we can’t have a law which says forbids people to buy stocks without first passing a test and clear thinking I mean cognitive limitations that are deeply rooted in the human brain could defy legal remedy but it is important that the law not assume that people are more rational than they are and then and this leads me to take a somewhat kind of view than I used to have securities or regulation I in a famous study George Stigler very great economist found that before the federal regulation of new issues in beginning 1933 purchasers of those new issues fared on average as well as purchasers of new issues do today so the SEC made no difference but the empirical evidence for that conclusion was always weak and the theoretical assumption that motivated namely the efficiency of the securities markets is now under serious attack the issuer has much better information about his company that even sophisticated outsiders such as securities analysts do and the potential gains to the issuer of getting the price of the new issue up very high often so large they dominate any reputational concerns that would normally inhibit sharp a dealing andrei shleifer his colleagues have been conducting very interesting comparative studies of the securities laws of the different countries in the world and correlating those laws with the performance of the securities markets in those countries and they have found that a basic security laws securities law that simply requires the disclosure of material information and provides private legal remedies you know like the 10 B 5 suits for the fair to disclose it so laws similar to the Securities Act of 1933 brings about a net improvement in the operation of stock markets though more ambitious forms of public regulation of securities markets do not so here they sort of new thinking about organizations about about the corporation about the compensation problem about the efficient market hypothesis converge to they say to all certainly alter my thinking about about the corporation and to provide a significant defense of at least the the basics of our legal regime for corporations and financial markets that was that was absolutely wonderful we had a sort of a romp through every issue an efficient market thesis in the discussion about everything regarding executive compensation and compensation across a whole variety of areas I assume your next talk will be on law faculty and Dean salaries and I can’t wait here that in any event Judge Posner has said he would be happy or at least willing to take some questions so I’d be yeah I am cynical I will gratitude I

will grant you that it’s a good working hypothesis that outside of I’m not even sure that I would need this qualification I was as the outside of family families settings the most powerful explanations of human behavior assume self interest in a rather narrow sense sewing pay any attention to protestations of corporate executives or law school deans about being motivated by by public interest so they all have jobs to do and constituencies to respond to and that doesn’t mean they don’t they’re not you know doing great work but they do great work because of because of environment that aligns their ins personal incentives with some public need but with regard but what’s interesting about these requirements for detailed disclosure of executive compensation it really provides the acid test for the exit for the excess compensation thesis because suppose these very detailed disclosures have absolutely no effect on executive salaries or investment behavior anything that can be measured well that would suggest that the market had known all along exactly what these executives were being paid and that whatever reasons there were that the compensation took indirect forms like stock options and all these perks the motivations may have been unrelated to any effort at concealment may have had with taxes or finance and you know risk and so forth or they or even if aimed it at concealment the market had seen through them and so they they would have no no effect so that would be interesting to see I would be delighted if it turned out that these regulations had no effect and then we could we could have fewer regulations yes well that’s a very interesting question nah I haven’t ever tried to do anything with that I should it is very interesting the law firm world you know as a as a as an enterprise commercial activity it’s it’s mysterious it’s what is mysteriously is the growth of firms the growth in the size of firms which has been so dramatic is a difficult for an outsider to understand one of the things that you would think would tightly limit the growth of firms is the very severe conflict of interest rules so the larger you are the more conflicts you encounter if you can only have you know one airline when I represent one airline for example then the larger the larger you grow the more you have to create a practice of you know one firm in every industry so so that’s that’s a puzzle as far as the compensation within the firm’s is concerned because it’s a large literature on that so some things seem well my one inside the law firm conversation what one observes is a reduction in lockstep compensation right

it used to be very common for firms to pay all the something to pay all the partners the same amount or all the partners in the same seniority level the same amount there’s still a few firms that do that but let’s become very rare and large firms and one associates that my associate that with a legal profession becoming more competitive because the more competitive a an industry the more pressure there is to match compensation with contribution to the extent you can that’s one of the way and that’s efficient use of labor so if you if you observe people of different productivity being paid very similar wages and it can’t be explained by the sort of team production idea they all have their individual practices they’re not that dependent on each other and yet they’re being paid the same and yet differ greatly in productivity to think well that’s not a very efficient labor market and I think it is clear that the legal profession has become more competitive partly because of Supreme Court decisions that knock down barriers to competition among firms this growing competitiveness of law firms and has has big effects on compensation it also has effects on quality of service and ethical standards in the legal profession because they’re in of course in conflict and you’re hired but you’re hired as a lawyer by someone who just wants to get his way when his case have have a contract one-sided in his favor what have you so he’d like you to do anything you know murder the lawyer on the other side bribed the judge anything but of course you can’t get your restrained by your ethical obligations but the more competitive pressure the more kind of under pressure you are to interpret your ethical obligations in as liberal form as possible so my prediction is that as the profession has become more a competitive the quality of service declines has risen but the ethical standards of the profession have declined now that can be offset you can have stricter scrutiny you can have and I think we’ve seen we’ve seen some some tendency in that direction so you can substitute some external discipline for an internal ethical obligation a professional a sensed professional obligation that was as my cynicism that was cheaper to indulge when there was less competition well that’s it that that seems to me closely related to the question of excessive compensation that is suppose that that there is really that isn’t that there is no economic justification for the average American CEO of being paid twice as much as the average a foreign CEO that would suggest that that the proper ratio you said 400 what the proper ratio would be no greater than two hundred to one now that would still be very height is another question suppose suppose we say that a competitive labor market will in fact pay a CEO of a major corporation 200 times as much as a worker is that a problem is that an is that and now first is that an economic problem why not I don’t it’s not an economic problem unless there is some secondary consequences of this inequality that is if everybody who works is paid his or her marginal product it is of course quite possible that someone’s marginal product is 200 times as great as someone else’s so that so there’s no

inefficiency there now inefficiency could rise if you had a lot of Envy in society lot of resentments if the people who were getting that will paid one two hundred were we’re angry and and took steps to to express their anger that that would be very serious that would be very staged now we haven’t seen that the United States is it striking lack of envy on the part of Americans it’s very interesting I do think though that one of the reasons for the concealment of CEO compensation is that companies do worry about public opinion as well as investor opinion and they would worry that if they were perceived as being too hoggish it might there might be repercussions form of regulation now on a purely ethical in purely ethical terms I agree with you the 200 or 400 21 is unjustified because the because because of the extraordinary role of luck in people’s economic fortunes and their there there’s their different types of luck some people would say well you know whether you have a whether you’re smart is lucky your genetic endowment as a matter of luck I wouldn’t I wouldn’t say that I wouldn’t go that far because you’d strip a strip people with all their individuality if you’ve said that everything have every asset they had even a even their innate assets were were pure happenstance but but as between two people with identical you know genetic endowments identical abilities one is it is quite likely to end up you know with a hundred times the income because of luck he went into he went into a field that boomed he had no idea it was going to boom he was just interested in it or maybe wasn’t good at anything else and all of a sudden he’s he’s immensely wealthy people who go to into lottery type work you know with very high risk of failure most fail a few succeed there is the disparities and income that result are just the product of luck so being lucky has no being born smart using your brains I think has moral worth but merely being lucky not as a result of not lucky you have created by really being able insightful you know foreseeing the future correctly but just sheer luck the the advantages one derives from luck the advantage when then passes on to one’s children you know by hiring tutors so they can get into fancy schools and so forth that there’s no moral defense of that on the other hand doesn’t mean you want to do anything about it because if you try to do anything about it probably make things much much worse off but one of the fallacies and I talked about people have difficulty thinking probabilities when the stupidest things greatest fallacies is that there is such a thing as luck so we have an adjective lucky which is perfectly appropriate some people are lucky but they’re not lucky because they have something called luck some asset the generated a good a good result right but because we tend to you know so these are nominal eyes lucky and say a lucky person is luck we think well yes a luck is one of your assets like your brains and so if you have a huge income because you were lucky that’s the return to your asset luck with which you were going right so that but I think that’s how many people think so so we do want to make sure that that it would be nice if they’re very wealthy people understood the degree to which their fortune was a product of luck that Hill go around you know preening themselves as geniuses because they just happen to be in the right place at the right time but I wouldn’t I wouldn’t want to do anything about that i don’t i don’t think i mean i think i think is a great thing for the united states that we have not had the kind of european envy of wealthy people which results in a lot of restrictions and labor markets

and so on tax policies that reduce the for example well I didn’t I didn’t tidy get I didn’t tie it in well and what I was saying I now I now realize what I what I had meant to say was that the behavioral finance does bear on the except on the excessive compensation issue because it suggests that the stock market is not as efficient in processing information as the efficient market hypothesis suggests so that means that a firm actually might derive a value from what seemed rather superficial methods of concealment such as not expensing stock options or not you know treating certain executive perks as current expenses or whatever tricks are used so there is that connection but what your your point though about weren’t these problems worse years ago was was not your suggestion so why is the prob why is the yes and yet and yet would where were the large institutional investors with that when um you know in Enron and all these companies were misbehave you know there’s that famous story but Enron the the analysts are given a tour of an Enron trading floor which had in fact had been completely idle and and run straight out and put a bunch of secretaries in front of laptops and they pretended to be traitors and the analysts were were deceived because they didn’t none of them thought of going up to one of these people and asking what you know he or she was actually doing which would have I’m asked the whole company right so fake have incomprehensible failure and I think be behavioral finance people would say that there was a kind of intoxication you know in the late 1990s about the market there were these you know people even like Alan Greenspan caught up in this the internet was going to transform things so this kind of waves of emotion sweeping through the market had no had no role in efficient market thinking I think I think there is there is certainly a motivational effect to this kind of tournament system in which you have these very huge rewards at the very top but it isn’t clear actually these benefit the company so suppose you have

some more or less fixed part of money to distribute among executives it’s not obvious that giving ninety percent of that pot to the number one person is and therefore only ten percent to lesser figures in the company is more efficient than reversing the percentages I think we have a sense that I think we I think we exaggerate the degree to which a single individual is responsible for the success or failure of a large institution and if you think that that responsibility you know causal responsibility is more diffused you may think well it’s actually more important to incentivize your second tier of managers than to find the absolute star to be to be your chief executive officer you know it’s striking how and how important luck does seem to play in the success of these people because so often read about someone had tremendous success turning around a company and so on and then he goes on to something else that’s a failure he goes on to a third thing that’s a failure and so and so you wonder the more the more that the the success of the chief executive officer is due to luck the less you should have to pay in order to get a a competency I don’t know if any of you who are about to go off to law firms who may have just heard one of the best arguments for increasing first-year salaries of associates that in any event thank you all very much this has been absolutely wonderful and I think a classic example of why everybody waits for each new article in book by Judge Posner because it passes through and crate gives incredible illumination of every area he puts his mind to and it’s always pragmatic always thoughtful and always provocative in any event I would like to invite all of you to join us outside that will be refreshments and I hope you can all continue the discussion there thank you all very much