Kenneth D. Gartrell

By: Kenneth D. Gartrell

Does the Federal Reserve Board birddog for the Congress? Does it help create big problems for the esteemed members of Congress to solve in pursuit of their passion to garner name recognition and political capital? What are the unintended consequences of these actions and what are the implications for the future.

Since at least 1996, the US Federal Reserve Board has performed the role as the Chief Bubble Buster in Charge of the US Economy. The culmination of all the bubble chasing has created a highly unstable domestic economic situation. In this climate, the Fed needs more than ever to be truly independent and stop (even inadvertently) acting as a political agent for central planning by a “jawboning Congress”. In allowing itself to be politicized so severely the Federal Reserve Board does a great injustice to economic science and limits its effectiveness and usefulness as competent guide for political/legal and economic progress.

Perhaps it is time to end altogether the Congressional oversight of the Federal Reserve. We have to be, as we stand today, concerned that such things as the serial appointment of Alan Greenspan during the 1990s and into 2004 compromised the independence of the Fed. Long-term reappointments for “going along to get along” can satisfy the needs of someone like Greenspan who palpably lusted for the label “smartest man in Washington.” Now, again the current Board and the Chairman seem even more inclined to do the bidding of Congress and at the same times lacks Greenspan’s great knack for obscuring and obfuscating even the most elementary aspects of economic thinking.

The Fed at times in the past has relished applying economic constraints under political pressures in Washington. Paul Volker, for example, led the assault on credit card rates in the Carter administration. This move did no cognizable near-term good for the economy, but it surely modified the political landscape by raising the misery index” to soaring and unheard of heights. It also did not do anything but harm for Jimmy Carter in the 1980 election cycle by fueling the Reagan Revolution.

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From Yahoo! Finance:

By John Wilen, AP Business Writer

Oil Jumps to Record Above $103 As Weakening Dollar Attracts Fresh Capital to Market

NEW YORK (AP) — Crude prices extended their march into record high territory Thursday, shooting up more than $2 a barrel as a falling dollar and the prospect of lower interest rates attracted more investors to the oil market. Retail gas prices, meanwhile, rose closer to records above $3 a gallon.

Light, sweet crude for April delivery rose $2.95 to settle at a record $102.59 a barrel on the New York Mercantile Exchange. Prices continued rising after the Nymex closed, setting a new trading record of $103.05 in Asian electronic trading before slipping back to $102.92.

A pair of dismal economic reports drew more money into the oil market, as did Federal Reserve Chairman Ben Bernanke’s comments that the economy is not immediately threatened with stagflation, a combination of economic weakness and rising inflation. The Commerce Department said gross domestic product grew at only a 0.6 percent rate in the fourth quarter, below estimates and at only a fraction of the previous quarter’s growth rate, while the Labor Department said applications for unemployment benefits rose by 19,000 last week, more than expected.

read more…

From Yahoo! Finance:

By Jeannine Aversa, AP Economics Writer

Bernanke Dismisses Worries About US Economy Returning to ’70s-Style ‘Stagflation’

WASHINGTON (AP) — Federal Reserve Chairman Ben Bernanke told Congress Thursday that the nation isn’t “anywhere near” the dangerous stagflation situation of the 1970s.

With the economy slowing and inflation rising, fears have grown that the country could be headed for the dreaded twin evils of stagnant growth and rising prices known as “stagflation.”

“I don’t anticipate stagflation,” Bernanke told the Senate Banking Committee. “I don’t think we’re anywhere near the situation that prevailed in the 1970s.”

“I do expect inflation to come down,” he added. “If it doesn’t, we will have to react to it.”

read more…

By: Kenneth D. Gartrell

Never mind what the Fed says ….it is already here in relative terms – likely to arrive this summer in real terms.

Recent news reports raise the spectre of stagflation: an abstract economic concept that arose near the end of the last oil crisis in the mid-1970s. It is supposed to reflect a world of incompatible conditions — that of low real economic growth – mostly in lost jobs — and that of increasing prices – mostly increased oil price fallout and interest rates.

When the misery of the 190s stagflation started to take a deep hold, we elected an unknown and untested President, a.k.a Jimmy Carter out of a desire for “change”. Now, I confess as a person, I like Jimmy Carter. But, his was one of the most failed Presidencies in US history. Jimmy spoke about the American malaise, created the Department of Energy, deregulated the airline industry (well partly), and suffered lots of embarrassment in foreign policy and military action.

I worked then in Cleveland when the misery index (interest rates, unemployment and inflation) peaked. After the catastrophic rise in interest rates, I felt the earth shake in downtown Cleveland. I kid you not the ground shook in the cold winter of 1979 when credit card rates spiked to 22%. Late summer 1980, there was hope in the air. The candidacy of Ronald Reagan was inspiring Americans everywhere. He ended up sooner in the White House and I ended later in a whole new world of opportunity after another stint of graduate school.

This year we have a hope/change candidate. But, is he a Carter or a Reagan?

What happened through the 1970s was, and it is going to happen again, that American consumers changed their behavior. Just one of the happenings of that era was the rise of Japanese cars in America. Never underestimate the power of American consumers or their ability to make rational economic choices and substitutions.

High quality, high mileage cars! How about a Smart or a Hybrid. Do you have any ideas what the same rate of adoption of hybrids will do the price of oil. WATCH.

It was a really good thing! And, by the time the substitutions were done and taxes and regulations were reduced, the shift in the Reagan relocation of defense spending from Midwest machine tools to West Coast electronics and information oil prices cratered from a recent high of $40 a barrel in 1980 to a mere $15 a barrel in 1986. If that happens again there will not be a glut of housing anywhere.

We don’t have some abstract thing going on called stagflation. We have high taxes, restrictive regulations that inhibit capital formation and innovation. Our Court system is far behind as our interstate system. And it has just as many unfixed potholes.

We also have excessively high oil prices born of bad public policy. The way out of this mess could simply not be clearer to anyone who struggled in the 1970s and 1980s.

The relevant political issue is whether we are again going to have a four year Cateresque Presidency or whether it will again be “Morning in America”.

This is not a partisan issue for me. Based on all candidates in the race, the middle on economic issues is to the left in this election. I think it is up to all of us as usual. Politicians do what our markets and we tell them to do.

I can, however, also say this without any hint of an endorsement, that, Mitt Romney is betting on a four-year Democrat President ala Jimmy Carter and he plans to be the Reagan of 2012. He may not be Reagan either — but he is thinking about it. Whatever else I think about Mitt, I don’t think he is stupid and I don’t think he cares who the incumbent will be in the next election. He probably thinks McCain can win the War, redirect the military and lose the economy ala Bush 41. He is probably also betting the Democrats will lose the War and strangle the economy.

Who knows? But, we can only go by what they are telling us policy will be. I really hope we do not have to wait four years for relief. Realistically though, it may not be time yet where we can do all the right things.

Further reading and views – pro and con

The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities

Structure and Change in Economic History

Our Stagflation Malaise: Ending Inflation and Unemployment

By: Kenneth D. Gartrell

The ongoing wave of white-collar crime prosecutions recently led by a spree of option-backdating cases raises some important economic questions about how to measure harm for sentencing purposes and some equally important questions about the relationship of overlapping civil and criminal proceedings.

Even though there is a single conceptual measure of economic harm universally acceptable to economists, there is no convenient single method to quantify damages or harm from option backdating. Every case is as different analytically as it is factually. The alternative methods have to be weighed against each other and ultimately reconciled. All the forensic tools of finance, economics and accounting must be jointly weighed with the facts to converge on the most reliable measure of harm. The Dura decision raises this imperative to even higher levels than before.

The difference between the market price of the company’s shares on the backdating and the price determined from but for cash flow analysis would be the correct economic measure of total potential loss regardless of whether a civil or criminal case. It is the only measure of harm that restores the victims to the instant before harm. Perhaps more importantly, it is the only equitable and just measure of harm that would in all cases rationally deter potential perpetrators.

Even though there is little disagreement among economists what constitutes the proper measure of economic harm, there is widespread opinion in the broader legal community. There are also legal/practical considerations that complicate the efforts to define and measure harm.

Reyes offers no keys

Until a month ago, the legal community thought that the Reyes sentencing would set the standard for application of Federal sentencing guidelines in option backdating cases (U.S. v. Reyes, No. CR06-556CRB). But, on January 17, 2008, Reyes was sentenced to 21 months and Judge Breyer found no provable harms. Without a measure of harm, the judge had to find another rationale to impose a jail term. It remains to be seen if the decisions can sustain an appeal and, in the meantime, no standard for the determination of economic harm developed from the case.

Prior to the Reyes result there was widespread speculation of how Judge Breyer might determine the measure of harm. It turns out the Court found that it was much more difficult to assess harm than was imagined in the speculation leading up to the final determination on January 17, 2008.

An accounting approach

“Reyes will give us the road map,” Professor Peter Henning speculated in an August interview. Henning suggested that judges might rely on the corporate restatement of earnings as a benchmark of losses even though the restatement of hundreds of millions in losses could have added five years to a prison sentence. Reyes’ company Brocade, for example, restated earnings to show $100 million in noncash expense attributed to options backdating.

Judge Breyer showed wisdom in bypassing the accounting measures. By themselves, the use of the retroactive financial accounting adjustments would not provide a reliable measure of harm. The accounting adjustment for the backdating options is to record an accrued expense for employee compensation allocable to the vesting schedule of the grant. It is only a bookkeeping entry and involves no outlay of cash. There would be no cash flow or valuation implications. The historical operating cash flows would remain unchanged and the proportionate claims to the dividend stream would remain unchanged.

Taken a step further in terms of the Dura decision, the fact of the backdating could not have been “generally known” before the actual grant date (see Dura). Regardless of any restatement, no one can go back in time before the actual grant date. The victims could not have been harmed and the defendant could not have benefited during the time that passed from the backdating until the actual grant date on the basis of the backdating or the accounting per se.

Schemes

As the Supreme Court left open in Dura, however, it is possible for a civil plaintiff to plead that a scheme was planned in advance and harm was done to shareholders from the time of backdating until the actual grant date and beyond because of a fraudulent effort to manipulate earnings. For an options backdating case, such a theory creates substantial complexity and insists on a type of analysis to determine economic harm as would be found in a typical 10-b5 class action.

A scheme, like the one alleged in the Reyes case, is a realistic possibility. As commentators have pointed out (see NERA) the practice of backdating options has been a part of business for many years and there is widespread sophistication in their use. Cases may exist, especially in short windows around earnings announcements and public filings, where backdating was anticipated in advance and was undertaken as part of a scheme to assure that promised immediate earnings targets were met. The expectation on the part of scheming defendants could have been to award each other unwarranted compensation for the attainment of the earlier earnings targets.

Cash flows and market prices

In a scheme, the financial accounting provides no reliable measure of economic harm. What would be required to allege, and later prove, damages (or by inference harm in the sentencing phase of a criminal proceeding) is a factually sustainable but for reconstruction of the manipulated cash flows — including tax effects, transactions costs, compliance costs and all other considerations having material cash flow implications.

In purely economic terms this ex ante cash flow analysis would be an unbiased and proper measure of damages or harm. But in a legal context, it is not possible to stop at that point because the Supreme Court in Dura decided on a need for an ex post determination of economic harm regardless of what can be shown about the but for situation at the time of the presumed harm. This imposes the need to consider the facts of when and where potential losses were “realized” by the plaintiffs or victims. It must be considered when, as the Supreme Court says, “the facts become generally known and as a result the share price depreciates.”

Economics aside, the Supreme Court has decided that there must be a “depreciation” of share price for harm in Section 10-b5 class actions. And, this introduces the further need to reconcile but for cash flow analysis to stock price changes isolated by use of event studies. It follows that because share trading continues between the date of true harm and the dates of share “depreciation” not all shareholders are harmed alike. Hence, some form of trading model has to be employed to quantify economic harm.

Under the rules, this type of analysis can scarcely be avoided. It gets very expensive and very fast. It is possible, moreover, that no causal link will ever be found in the analysis that connects the option backdating to demonstrable harm to the victims. In the most elaborate schemes, with the most planning and with the most sophistication there are many escape routes available.

In the earlier speculation about emerging standard, some lawyers offered the view that stock price drops are inappropriate for backdating cases “ because it would be hard to show backdating affected investor decision.” Hard? Yes. Quite so, but the Dura decision says it needs to be done both to plead and prove harm sufficient for damages in a civil securities case under Section 10(b). Could the requirements for the proof of harm be any less in a criminal matter? Ultimately, we would not expect a difference.

Accounting revisited

Obviously, the complete determination of actual economic harm via cash flow analysis is fraught with complexity. And, this is where it may be feasible to reintroduce the prospect of using the accounting compensation calculations as the measure of harm. On the basis of long-established professional custom and practice, an accounting expert could opine where a scheme is present that economic cash flow analysis is subjective and unreliable and that the ill-gotten gain manifest in the schemed for compensation provides a quantification of harm which is “more objectively determinable.”

The Courts rely on the testimony of both economic and accounting experts. Accountants have an economic interest in having their particular methods applied. Further, in a world of perfect information and low transactions costs, there should be no difference between the economic loss sustained by a victim or plaintiff and the ill-gotten gain enjoyed by the defendant.

A rebuttal to this method exists, nevertheless, because the formal accounting principles concerning the calculation of option-based compensation would at its core only be a shortcut to the ultimate cash flow analysis. The option-pricing model is only as good as its assumptions. The market price used in the model ex ante would have to be the but for price of the security on the date of harm. This, in turn, can only be calculated from the discounted cash flow analysis. It does no good to back cast based on observed prices at the grant date.

Before and after period

An article on Law.com by Pamela MacLean observed “… Northern District of California Judge Charles Breyer, who will sentence Reyes in November, has signaled his unwillingness to use a single stock price drop event to calculate losses for sentencing purposes in a 2003 fraud case. He settled on the average stock price for 60 days during the fraud and the 60-day average after the fraud to show the loss. U.S. v. Grabske, 260 F. Supp. 2d 866…”

Perhaps there is little more than irony in the fact that Dura was a Supreme Court decision to reverse a ruling by the Ninth Circuit “ that loss causation (could be established) …simply by alleging and in the complaint and subsequently establishing that the price on the date of purchase (harm) was inflated merely because of misrepresentation.”

Whatever the thinking or motivation could be behind such an approach the Judge again acted wisely in not adopting it. No sense can be made of it of in terms of modern financial economics. The field has maintained, over decades of research and testing, that stock prices follow a random walk. As such, there is no information in the historical trends of a given a stock that predict the future trend. This finding is a central tenant of the Efficient Markets Hypothesis and it stands behind the entire legal theory of “fraud on the market.”

Hence as Professor Eric Lie shows in his option backdating lookback analysis, anything can happen to the price — even in a shorter 30-day lookback period. A 60-day period does nothing to resolve the fact that stock prices are not structurally stable within a 60-day period, let alone across two concurrent 60-day periods.

Lesser of intrinsic value of compensation or actual cash benefit

A final proposal from the early speculation proffered that the most logical calculation would be the difference between the “backdated price and what the price should have been, then factoring in the number of options actually exercised to purchase stock shares….”

Actually this is just another version of the ill-gotten gains versus cash flow analysis discussed above. The only apparent virtue of the approach is simplicity. But, it still confronts all the same issues as before except for the simplifications that:

1) Reduce the measure of compensation or ill-gotten gain to intrinsic value of the option (which is what I take the language — backdated price versus what the price should have been — to mean), and

2) Reduce the measure of damages further to the gain actually realized by the defendant upon exercise.

The approach would satisfy neither the economist nor the accountant professionally. Accounting has long since moved beyond intrinsic value standards. Economics, furthermore, would find at least two major faults in these restricted metrics. First, even at the money options, due to the elements of risks associated with future events, have positive value even when the apparent intrinsic value is zero. Second, basing the harm on the realized exercised value would be akin to limiting the harm done by a petty thief to what he or she can sell a stolen camera for at the local pawnshop. It would have to be a discount below fair market value due to expedience and other marketing costs. The real loss to the original owner would be fair market value of the stolen camera plus the transactions costs to replace the camera.

Law of One Price

Unequivocally, the ex ante difference between the observed price of the stock affected by option backdating and its but for price is the theoretically correct measure of economic harm done by the backdating and/or the scheme it represents. But because of factual ambiguity and because of the constraints of Dura the analysis requires a many faceted approach. The differences in proposed measures are not differences in kind, but rather differences in perspective.

The differing elements of the preferred but for analysis are not independent. They are all part of the same fabric and only represent alternative routes to the same underlying conclusions. In a perfect economic world with no information costs or transactions costs, there is only one measure of harm. Conforming to the “law of one price,” the cash flow analysis and the accounting analysis will agree as two sides of the same coin — just as the cash flow analysis must agree to the analysis of realized harm from stock price depreciation when the “facts are generally known.”

For any case to be decided in advance based on a pre-selected method is the same as to decide the facts ahead of time. The correct economic approach for the quantification of economic harm is to use all the facts in a forensic fashion to converge on the correct measure of harm with a full understanding of a need for the reconciliation of the methods. When there are apparent differences across methods of analysis there is often compromise at some middle ground. No matter what the pathway is, it cannot be engaged independently. The actual available path in each case is entirely dependent on the facts of that case in an “imperfect world.”.

The laws of economics as interpreted directly by economists, or inferred by way of the customs and practices among accountants, do not change because a particular case is a civil case or a criminal case. How could a situation long endure that treated the same thing in a civil case with lower standards of proof differently from a criminal case with a higher standard of proof? If a certain approach or philosophy is required to meet a lower standard of proof, then it would seem most certainly that the same approach would be required to establish harm at a higher standard of proof.

Grants-MS.pdf

Grants-JFE.pdf

PUB_Backdating_Part_2_Primer_SEC1502_final.pdf

Supremes Dura.pdf

TestimonyErikLie.pdf

By: Kenneth D. Gartrell

Get a license to carry a concealed weapon…at least that is what I did?

When we make economic decisions we weigh the marginal cost and the marginal benefit of the decisions we are making. But as this tale tells, the point at which we assess the marginal cost and benefit can influence a great deal whether we will take a certain course of action or not.

I like to take occasional trips to exotic places in the world and spend a few days fishing and shooting. Most of my shooting is done with clay pigeons at places like Sandanona, NY or at Holland and Holland in London. I also enjoy the company of good friends who prefer with me to bag our own Hungarian partridge and pheasant for gourmet cooking. I am not fanatic about any of this, but it does provide rewards that are not so common in everyday life.

Until recently, I never owned a firearm and just used what was at hand wherever I visited.
When I finally decided to get my own firearm, I ordered a custom made shotgun from the AyA factory in Spain. I, unwittingly, set off a string of activities that raise interesting questions about how people economize in the face of complex regulations. The following is brief recounting of the experience that followed.

I live in Boston. Firearm laws here are very strict for anyone who seeks legally to have any kind of firearm in their house for lawful purposes. I live near in the Historic South End and often it does not appear that neighboring teenagers roaming the alleys behind all these multi-level, multi-million dollar, Civil-War era townhouses face the same restrictions on firearms as the taxpayers. But that aside, I want to focus on what you must do to own a classic custom firearm and keep it in a locked safe in your Civil-War era townhouse for a once or twice yearly trip to France, Corsica or some other pristine destination.

Once I ordered my firearm, I had to have it shipped to an authorized and licensed firearms dealer in the Boston area. Federal and international mail restrictions, as well as firearm regulations, strictly prohibit shipment directly to my home. I did exactly what I had to do and when the firearm arrived after about a two-year wait (hand crafted firearms take longer to make than zip guns), I went to the appointed dealer to pick up the firearm. But, I was unable to take delivery because I had forgotten a little detail. Namely, that in order to get the firearm; I would have to supply a Federal Firearms Identification Card. I was truly remiss because I knew this was a requirement – it is just that you forget a lot in two years.

I backtracked to find out what I needed to do to get a FFID. The result seemed relatively painless. I was told all I needed to do was come to the new central police station near my house and make application for the ID and pay a fee.

In a day or so, I arrived at the police station and I was sent courteously to a window staffed by a uniformed police officer. Learning what I wanted, the officer invited me around behind the counter. I was promptly fingerprinted and I filled out an array of forms.

Then, the officer questioned me on my need for a firearm and my intended use.
I was told that in order to obtain an FFID in the City of Boston, I would first have to take a firearms safety course (reasonable) at a local gun club. The officer gave me the needed registration information and recommended a gun club in neighboring Dorchester. He was kind enough to point out that this was a good safe place. New police received their training at this club and veterans often went also to practice for their own fitness tests.

That night, I went home and called the gun club and made a reservation for the very next week to begin a four-week training course on Saturday mornings. At the appointed time and place, I showed up for my training. As I made my way through the maze of locked doors, I found my way into a classroom where other students awaited the instructors.

The other students were not like me. Most of them were younger and all of them were there because they needed to carry firearms in their line of work as private security guards. I felt a little out of place, but I decided I needed to follow the rules and do what the police asked.

The firearm safety class was divided into a combination of classroom instruction concerning Massachusetts’s firearm laws and hands on training, cleaning and firing in an enclosed range with classic police revolvers. The instructors were also proud to show off their personal collections of Glocks, Berettas, and WWII style Colt 45 automatics. I confess this all caught me by surprise, but step-by-step I found myself all the more fascinated.

After four weeks, I passed the course and I had established that I could score at least 240 out of 300 with 30 rounds on targets as close as 20 feet and as far as 50 feet. To tell the truth, I was proud of this accomplishment. It was not anything I ever had in mind and it was a far cry from my original intentions. Still, there was psychic reward in learning how to handle a dangerous situation with some air of confidence.

Four weeks later, with my certificate of training in hand, I returned to the central police station to meet with the same friendly sergeant as before. He agreed that I had completed all of the needed work for the FFID and for a small fee he was prepared to have one issued to me. But, he said “Considering that you have come this far, I recommend that for a small additional cost of money and a one day visit to the police firing rage on Moon Island, you apply for and obtain a license to carry a concealed weapon.”

His reasoning was flawless. He pointed out that the small incremental cost was eclipsed by the incremental benefits. He explained to me all the reasons why in the future I may want a license to carry. He explained that it would not be a good thing to stop at the FFID and come back later for a license to carry. He said it would look suspicious in case something dramatic and unexpected should ever happen any of my firearms. I saw his logic and on top of that I was made a little fickle by the potential bragging rights that go with qualifying as a police marksman.

A few weeks later after a lot of range practice at nights at the Dorchester club, I went to Moon Island and stood on an icy firing range to shoot my 270 out of 300 over 30 rounds at 50 feet and earned the right to get and keep a “license” to carry a concealed weapon.

Proud of my accomplishments, I retuned to police headquarters the next week and finished the process. This time there was a new hitch. Since I had last visited, I was told it had been decided by the new officers in charge of the department to issue licenses to carry for recreation use (limited to back and forth to the gun club) only on a restricted basis. Since, I never planned to carry or own a handgun that seemed unobjectionable to me, so I paid the fee and got my stamped restricted license.

Not long ago, I learned by chance that my “license” to carry was always pretty useless because impossible legally buy handgun in Massachusetts and it is illegal to buy one out of state and bring it home.

But, I do finally have my Spanish shotgun and here is an accounting of the total cost to acquire:

Shotgun cost including shipping and duties $15,000.00

Pickup fees 100.00
Training course 250.00
Licenses 100.00
Ammunition for training 200.00
Opportunity cost of total training time 16,000.00
Opportunity cost of total application time 4,000.00

Total cost of custom firearm $35,650.00

The moral

There are at least three economic lessons in this little tale.

First, when making economic decisions it matters a great deal where we define the margin and how clearly we understand the incremental costs at that point. In this case, it is fair to suppose I would not do all this all again. If I had gathered my information before hand, I would not have considered the incremental benefits greater than the incremental costs. I had simply wandered logically and incrementally through the maze. At each point, the marginal benefit seemed to equal or exceed the marginal cost.

Second, there is a lesson in just how complex firearm regulation can get. I never conceived how price discriminatory and discretionary the regulations could be. I have no objection to the fact that I cannot carry a concealed weapon. It was never my intention. Still, I am impressed at all the costs associated with the firearm regulations. I have to wonder whether the relative cost of all types of regulation are the same.

Third and finally, perhaps the most interesting, lesson is how effective the Boston Police were in getting me to subsidize them via my support of the firing range where they train. They also did a clever job in getting me to line the licensing coffers that help pay their salaries to enforce the fireman laws.

By: Kenneth D. Gartrell

Law firms optimally combining size and leverage appear to be the most profitable.

Are they also the most interesting places to work, with the most attractive career potential for entering associates who have high value added skills and degree combinations that can engender innovation, profit and growth? This exploratory analysis provides suggestive indications that law firms are pursuing strategies depending more on the dimensions of staff skills, organization and culture than on the brute force of size or the limitations of narrow specialization.

Among law firms, the firms that consistently top the list of the most profitable firms on a per partner basis are neither the largest firms nor the smallest firms. They are somewhere in the middle. This suggests that the benefits of size are not ever increasing, but that some size is needed to sustain profit-maximizing levels of staff leverage. Is this true or are the profits among the medium size firms merely a reflection of transient conditions such as the specific industries a firm serves at a certain time?

Law firms provide an interesting place for organization and strategy specialists to examine theories of organizational economics. The legal profession is a large and relatively homogeneous industry. Across the United States there are hundreds of law firms and sufficient information about these organizations and their business activities exists to allow a level economic inquiry that is not so readily possible in most other industries.

Law firms vary widely both in size and in the ratio of associates to partners working for the firm. The former relates to the scale and scope of operations. The latter called the leverage ratio relates to the use of junior staff at higher profit margins per hour than a partner. At first impression it appears some scale is required to achieve higher levels of utilization. But, it also appears that beyond a certain point, size and leverage cannot both be sustained.

Continue reading: In search of excellence in the practice of law?

Cross-posted from Adam Smith, Esq.:

By: Bruce

From the Journal of Economic Education (hat tip to “Truth on the Market“) comes the first study I’m familiar with examining whether the choice of undergraduate major has any effect on a lawyer’s career earnings. And guess what? If you major in economics, it helps; majoring in anything else makes no difference.

Here’s the abstract, in full (emphasis supplied):

“Using nationally representative data, the authors examine the effects of preprofessional education on the earnings of lawyers. They specify and estimate a statistical earnings function on the basis of well-established theory and principles. Along with standard control variables, categorical variables are included to represent graduate degrees in addition to the law degree and an assortment of undergraduate major fields. Holding a Ph.D. or M.B.A. degree, with the law degree, is associated with significantly higher earnings in some sectors. Lawyers with undergraduate training in economics earn more than other lawyers, ceteris paribus, and economics is the only undergraduate field associated with earnings that differ significantly. The available evidence supports the hypothesis that economics training increases a lawyer’s human capital compared with other undergraduate majors.”

That still doesn’t mean Adam Smith would become a lawyer were he alive today; but I know in my heart that he would have an active and energetic blog.

View pdf by clicking the above image or by clicking here…

By: Kenneth D. Gartrell

Some people say the problem with America is that we have too many lawyers. It is an old idea, but not a very good one. A better way of thinking is to look at the constructive institutional development of the legal profession.

Recent trends indicate the entry of young arbitrageurs into the legal profession. Most are young associates. Most are woman. Most have some international connection. Most have a background or interest in corporate finance and corporate control.

THE GAP

My provisional estimate gauges the Federal and State Court systems no less that 50 years behind on average in handling economic questions for which answers are well known to the average MBA student in American business schools. In light of the rate of potential applications for our knowledge this is an expansive gap.

Judges know much more than juries, of course, but the average judge has little formal training in business or economics. He or she is also older and was likely educated before the rise of modern financial economics marked by wide acceptance in graduate schools of business and economics in the 1970s and 1980s.

On an impressionistic basis, formed over a limited personal sample of 100 cases and 30 appearances in various legal forums over the last 20 years, I place the financial economic sophistication of the legal system on average in the early 1960s. As we fast approach the second decade of the 21st Century, we approach the 50-year gap in knowledge if my assessment is unbiased.

In this immediate realm it should be true, as it appears in all of nature that “nature abhors a vacuum.” The puzzle is to understand what structure and process has developed or will develop to resolve the gap. Speaking institutionally, it is up to the broad legal profession to make a way. As fortune would have, it does appear dynamics are in motion within the broad legal profession.

A SOLUTION

In markets generally (for those of us who believe in such things) this type of “knowledge gap” represents an arbitrage opportunity, a chance to profit by more than a normal rate with less risk than general. It appears bright young people looking for a good income and a chance to make a difference in life see this gap. They pursue career and education strategies to close it with the aid of opportunistic law firms.

THE PLAYERS

MBA, BBA and economics graduates are among the most inclined to entrepreneurism. On this basis, I decided a good way to look for action aimed at closing the legal/financial economics knowledge gap was to observe recent movements of business and economics students into the practice of law.

EXPLORATORY RESULTS

In order to test my ideas about the knowledge gap, I performed a web search of the top 250 law firms in the United States. Here are some quick findings. Most of those with combined business, economics and law educations are:

• Woman,
• Associates,
• Less than 5 years from law school,
• Multi-lingual,
• In highly profitable New York law firms,
• Internationally aware,
• Finance focused,
• Practicing in Private Equity,
• Corporate Departments,
• Employee Benefits,
• Securities,
• Restructuring
• Derivatives, and
• Capital Markets.

OVERALL PATTERNS

Noble Laureate Gary Becker has been following the creation and flow of human capital for a long time. He has much that is valuable to say about it. In his book “Human Capital”, he discusses both the flow of women and selected international populations into the ranks of higher education and the substantial economics incentives that surrounded it in the recent decades.

In my work as an expert witness over the last 20 years, I have tried to bring all the principles I’ve learned as a scholar and teacher in business economics into the courtroom. I have always felt it was my calling to transfer this knowledge for the unbiased use of the fact-finders whether judges or juries. But, because of many complex factors I have to say the results have been mixed.

It gives me heart to see the trend to legal entrepreneurism. Based on the exploratory evidence of this limited survey, I have embarked on a larger research project to provide more detailed and more penetrating analysis of the thesis.

By: Kenneth D. Gartrell

The first law of economics should be that on the margin, little things mean a lot. The good news is that the Dismal Science is growing in popularity and people are more receptive than ever to such powerful intuitions. It is in popular books at the books stores near us. Business and economic media is one of the fastest growing segments of the news and commentary markets. Economic Weblogs appear in many forms.

We all face everyday questions requiring us to think for ourselves more clearly and effectively in economic terms. Can you give a simple economic explanation for why a beautiful new country club has hundreds of un-repaired ball marks on otherwise perfect greens and why the tee boxes are strewn with broken tees? Can you recommend the least cost and most effective way to solve the problem?

When we can think more clearly about these digestible questions, we can start to think about bigger things and tougher issues.

A growing popular desire to unravel the mysteries of practical life, as well as poverty and prosperity, explains for me an exploding interest in books on economics such as Freakonomics, Capital Ideas and more. It also explains why there is a rise in the business and economic media. We even see a trend towards the popular diffusion of economic thinking as it begins to rival murder tabloids on major cable networks.

It all reassures me in human nature and about the worth of all the economic study up to this time.

We are bombarded daily with big and complex questions like: “Is Social Security a good thing?” “Did the Federal Reserve Bank cause the NASDAQ bubble?” Will the Federal Reserve solve the housing crisis? These questions are obviously matters of economics. Other questions such as: “Should I worry about my Medicare benefits?” “Will there someday be a cure for cancer?” “Will a wall on our borders make us safer and more prosperous?” are not so obviously economic questions – but in their true underlying character they are!

The way to address ALL these questions is to learn the simplest intuitions of economics and then use them to break down the complex questions one part at a time.

AND THE ANSWER IS:

SO THE LESSON FOR THE DAY IS: On the margin little things mean a lot.

By: Kenneth D. Gartrell

I am not a lawyer. So, maybe a lawyer can explain to me how in our securities law under Section 10-(b) we can abide different standards of economic analysis to arrive at judgments about essentially the same thing. I was confronted with this paradox of proof for the first time when working as an expert in an insider trading criminal trial. Let me relate the issues briefly for now. I will be able to return a detailed case study at a later time when all the follow-on maters are decided.

THE INSIDER TRADING CASE

I have previously worked in 10b-5 class actions. I have been a financial economist all my life, so it seemed logical to me to examine the issues in this case from the perspectives of the tools, techniques and concepts common under the Section 10b-5. I was frustrated in my efforts. I am puzzled why such seeming scientific inequities would exist.

In this insider-trading case, where the “material” value of alleged insider information was essential to the facts, a verdict was reached on circumstantial evidence related primarily to patterns of document access, phone calls between the alleged tipper and tipee and selected trades of the alleged tipee. The relevance and worth of the information was either inferred or established by testimony of fact witnesses not obviously familiar with the type of research done in financial economics and the conclusions reached from it.

For reasons of legal strategies, time pressures and judicial discretion, the jury in this case never had the benefit of an economic analysis of the rich, but sophisticated, information environment where the alleged tips occurred. They also did not have the benefit of an assessment of the “market value” of the information in the proprietary investment bank documents from which the alleged tips had been taken. And, finally the jury never had the benefit of an informed independent economic analysis of the tipees trading patterns as it pertained to the backdrop of the mix of information on the market.

CONTRAST WITH CLASS ACTIONS

In 10b-5 class actions for “fraud on the market” the materiality of disclosed or undisclosed information to the market would be evaluated by the “event study” methodology and related analysis of cash flows and accounting — wherein materiality means that such information moves price by more than expected compared to daily unexplained variations due to chance.
In this one insider trading case at least, the concept of materiality was left broadly undefined for the jury to decide. I have to infer this happened because there is no similar precedent of measurement in insider trading cases that parallels class action cases.

The disparity between the insider trading cases and the class actions promotes a somewhat stark realization. A seemingly competent and promising financial professional, for instance, could go to jail for much of his life on the basis of providing information (assuming he did as the jury found) that most financial economists would agree could not sustain damages in a civil class action.

I do understand that the question of harm is examined separately as a matter for sentencing in a criminal case. I believe, nevertheless, that a careful information-based analysis in this particular insider trading case would have cast a large dark shadow of doubt on the more basic questions of guilt or innocence. Understanding fully the true nature of the information that had been allegedly conveyed from the tipper to the tipee, the jury may have viewed all the surrounding circumstantial evidence in different light and accepted more innocent alternative explanations for it.

Aside from a technical consideration of legal precedent, perhaps the other bigger issue is that we have come too far in the criminalization of business conduct. The thrust of the current wave of FCPA and Sarbanes Oxley investigations — coupled with potential for misplaced, ambitious and politically motivated prosecutorial conduct — risks abuse to our market systems. From the point of view of an economist, the process we have now, complete with the kind paradox observed in this one insider trading case, suggests hastily proliferated, over-blunt regulations. It will be up to lawyers and judges who practice in this area to bring rationality and discipline. My suggestion is that we look for consistent applications of economic analysis between criminal and civil matters as one way to alleviate potential anomalies.

http://management.about.com/cs/businessethics/a/InsiderTrade702.htm

http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2003/06/15/BU292506.DTL&type=business

http://www.sec.gov/answers/insider.htm

http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm

http://www.washingtonpost.com/wp-dyn/content/article/2007/06/13/AR2007061302197.html

http://64.233.169.104/search?q=cache:bxe5ke1JeXIJ:www.akingump.com/docs/publication/683.pdf+insider+trading+cases&hl=en&ct=clnk&cd=15&gl=us

http://www.nypost.com/seven/10262007/business/sec__insider_trading_rampant.htm

http://blogs.wsj.com/law/2007/05/09/talkin-insider-trading-with-former-sec-top-cop-harvey-pitt/

http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.html

http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=ayngJ4XBYwTg

By: Kenneth D. Gartrell

Unless the laws of man can keep pace with the advance of science we will live in a stifling world where innovation and enterprise goes unrewarded. Such a world would be arbitrary and capricious. Worst of all, it would be without promise.

As I initiate this Weblog, I’ve got a simple idea. I want to see us living happily in a world where the laws of man, as observed in the public forum, conform to the laws of nature.

I intend a journey of discovery and enlightenment. It begins with the premise that the laws of nature, as they have been expressed to me over the course of a lifetime in the science of business and economics, are pathways to the future and a better life. Based on repeated observations, it follows on with the further assertion that the administration of our laws lags too far behind the advance of our science.

How much? I don’t know exactly, but I will try to estimate as I go.

I provisionally believe our social, political and legal institutions lag the advance of science in financial economics by approximately 50 years. We are, consequently, suffering needless setbacks and burdensome restraints because our lagging political/legal institutions command property rights through the allocation of rewards and punishments from both collective and individual effort. While some degree of conservatism and skepticism in the allocation property rights seems productive for the sake of stability and order, it appears to me that a time for breakthroughs is overdue and at hand.

Whatever the true status of overall institutional affairs may be, it is worthwhile to explore the issue. If a 50-year gap in the administration of property rights is desirable then it is a good thing to know. It would seem, however, that such a gap is less than optimal on average because it approaches the span of an entire human generation between innovations and the final settlement of associated property rights.

There are uncounted swirling ideas and thoughts at the core of what motivates my thinking about these issues. It seems to me a Weblog is a fair-minded and constructive way to sort out the ideas and thoughts. With all the preceding structure and process in place the joint missions of the Weblog are:

1) to assess objectively the status of the gap between our political/legal institutions and our scientific institutions; and

2) to provide helpful observations at the joinder of law and financial economics focusing on the opportunities we have to manage our energies more precisely and more efficiently.

My intended audience is primarily comprised of those who would share my interest in the overlap of the law and financial economics including members of the legal community, financial professionals, corporate executives, and an occasional politician. I hope you will come to appreciate and enjoy my perspective.