Hypothesizing Regulatory Instability

Erik Gerding’s recent book, Law, Bubbles, and Financial Regulation, is an ambitious and fascinating project that seeks to explain how asset bubbles—a perennial staple of economic history—lead to and, in turn, are exacerbated by financial regulation. Gerding makes it clear from the outset that his goal is to move beyond “fixing immediate symptoms” of a financial crisis and try to uncover the fundamental factors that explain how disasters happen. To this end, he advances what he calls the Regulatory Instability Hypothesis, a conceptual framework for explaining how financial markets (traditionally, a realm of private ordering) and financial regulation (the public sphere) get locked into a deadly spiral leading to a crisis. Gerding identifies five key dynamics that define this interaction: the regulatory stimulus cycle, compliance rot, regulatory arbitrage frenzies, pro-cyclical regulation, and promoting of investment herding. His Regulatory Instability Hypothesis holds that these five distinct dynamics pose danger to financial stability by undermining laws and regulations designed to protect it.

In my opinion, one of the most interesting and novel elements of Gerding’s argument is his concept of the “regulatory stimulus cycle.” Various scholars before Gerding wrote about the multiple causes and consequences of various deregulation campaigns, including privatizations of previously public functions and repeal of specific laws viewed as constraining private markets. In the aftermath of the latest financial crisis, in particular, many were searching for specific legal mechanisms that enabled unsustainable growth in risk and leverage within the financial system in the pre-crisis decades. For example, some scholars argued that the latest crisis could be traced directly to the partial repeal of the Glass-Steagall Act in 1999 and/or the passage of the Commodity Futures Modernization Act of 2000—the two most significant deregulatory legislative acts in recent times. Others (including myself) have focused on specific regulatory or legislative actions enabling financial institutions to conduct business activities that fed the pre-crisis asset bubble.

Gerding brings together all of these strands to construct a convincing and creative explanation of the entire complex of legislative and regulatory actions and failures to act, which form a single historical pattern that cannot be reduced to a simple notion of “deregulation.” Gerding argues that asset bubbles and busts create similar cycles of “regulatory stimulus” (which encompasses “loosening” of various legal restrictions on bubble-conducive financial activities) and “regulatory backlash” (which inevitably follows an implosion of the bubble). He analyzes this phenomenon of regulatory stimulus through three theoretical lenses—public choice, behavioral economics, and social norms—and demonstrates the complexity and multiplicity of factors that create and reinforce pernicious regulatory cycles. Gerding’s argument is original, thoughtful, and quite illuminating even for those of us who are well-versed in this subject-matter.

Gerding follows a similar approach when he examines the complex factors behind the other four aspects of his Regulatory Instability Hypothesis. He continues this densely packed discussion, which forms the bulk of the book, by applying his conceptual framework to the Panic of 2007-08. Here, Gerding shows his mastery of the rise and growth of the so-called shadow banking system, which he uses as a vivid example of the bubble-bust dynamics not only in financial markets but also in financial regulation.

The last part of the book lays out the author’s vision of how to design a more effective and adaptive financial regulation that would be less vulnerable to the pernicious dynamics of regulatory instability. It’s a sweeping but thoughtful discussion of high-level principles of regulatory design that could potentially alleviate specific problems he identifies earlier. While admitting “profound challenges” of trying to counter these deeply-rooted dynamics, Gerding methodically catalogues a wide range of measures aimed at redesigning regulatory institutions, with a view toward breaking the historical pattern of boom-and-bust cycles. Necessarily lacking in specificity, this forward-looking discussion nevertheless is very impressive and effective as a conceptual framework outlining the avenues for future policy work in the area.

As with any large-scale and ambitious work, Gerding’s book may invite legitimate criticism on a variety of specific points. I do not agree with every statement, diagnosis, or recommendation for future reform that he advances in his book. I would even argue against some of his assertions (and, especially, some of his recommendations). If I were writing this book, I might have chosen a different theoretical device to construct the argument. Yet, none of these disagreements diminish the significance of the book. On the contrary, by defining the contours of the debate and creating a helpful vocabulary for discussion, Erik Gerding’s new book provides a great benefit to the scholarly community. To be sure, this book is a dense read that requires an extra effort from its readers. Yet, the result if well worth the effort.

Cite as: Saule T. Omarova, Hypothesizing Regulatory Instability, JOTWELL (January 7, 2015) (reviewing Erik Gerding, Law, Bubbles, and Financial Regulation (2013)), http://corp.jotwell.com/hypothesizing-regulatory-instability/.
 
 

Surmounting the Control Paradigm

Colin Mayer’s Firm Commitment is not exactly a book about corporate law, but it’s still best corporate law book I have encountered in a long while. Here a leading academic in business and finance challenges the status quo, bringing financial economics, agency theory, and corporate law to bear to persuade us that something has gone very wrong with corporate organizations in English-speaking economies.

Unlike many critics of corporate institutions, Mayer approves of large corporate entities. He points out that they allow us to partition assets off from individuals and create stable productive environments conducive to group participation. They are ubiquitous for very good reasons and do great things. But there’s also a dark side. In describing it, Mayer pulls together a number of things that we all know are out there and builds them into a binary theory. On one side of the description there’s a long list of phenomena, bundled up and characterized as the “control” paradigm. The market for corporate control sits at the top of the list, followed by environmental degradation, reductions in workforces, the shareholder value maximization norm, the trend to shareholder empowerment, short termism, leveraged restructuring, asset substitution, and leveraged speculation. All these work together with and within corporate entities to lead to disastrous results for society and the economy, manifested in the form of both externalities and opportunity costs. As society tries to cope with this onslaught of injury, there result layers and layers of choking regulation.

On the other side of the description of corporations lies commitment, conceived as the restraint of control. More particularly, there are layers of unenforceable cooperative obligations that encourage stakeholders to invest in corporate enterprises. Indeed, it’s the genius of the corporate form that it encourages people to make these commitments. Yet, in the English-speaking economies (especially the UK), corporations are not taking advantage of this possibility due an obsession with control—a sacrifice of all to the interests of market shareholders. Other national economies have more stable corporate environments protected by controlling families or corporate groups, and their corporations do better in the sectors where commitment matters most.

This is a formidable indictment of the mindset that has held sway in academic corporate law for the past three decades. The same mindset more and more holds sway within corporate boardrooms. Mayer’s description and diagnosis pull no punches, occasionally crossing the line over to argumentative exaggeration. Even so, I can’t think of a more persuasive account. The question concerning constituent commitment has been fundamental to corporate law and governance for those same three decades, and no one has done a better job of laying it out.

Mayer would like to see some structural changes made in corporate entities, administering a strong dose of what’s called “new governance,” although the appellation doesn’t seem right for a book as hard hitting as this one. If you need to constrain corporate decision-making, says Mayer, it’s better to look inside the firm and take advantage of better information and more focused incentives than to look to outside regulation. He celebrates corporate diversity, counseling us that there are all sorts of organizational ways to make a widget and that some modes are better suited for some production functions. It’s not the one size fits all agency account that we hear in the conventional wisdom.

He gives us a two part reform suggestion. The first part is a weighted voting scheme that instead of rewarding with more votes as the holding period extends, rewards more votes up front in exchange for an advance commitment to hold for five or ten years. The second part is a variation on two-tier governance structure: a board of trustees whose job it is to assure that management adheres to a statement of purpose, a statement that by definition is non-shareholder value maximizing in significant respects. The trustees shield the firm from market pressures, enabling commitment.

Question: Is US law flexible enough to facilitate Mayer’s trust firm? Our corporate codes certainly are, if one reads them literally. You can draft any kind of voting and governance scheme you want into a corporate charter. But there still could be some questions about the operation of the duty of loyalty mandate on a board of directors subject to other constituent-directed trustee instructions. And, in fact, there is a narrow range of situations in which favoring employees over shareholders might be a breach of fiduciary duty, although I don’t think the range is economically salient and I doubt it would seriously get in the way of anything Mayer advocates. Even so, the theoretical implications are sufficiently momentous that I suspect a bit of statutory tweaking would be necessary to bring in Colin’s trust corporation, much as we have seen happen with B Corporations.

Tweaking aside, the lawyer in me wants to make a larger point about the connection between corporate law and the adverse conditions identified in the book. While the law facilitates the conditions, it does not require them. The law allows companies to merge and the removal of antitrust barriers makes mergers easier than ever. Yet there are no legal shotguns at these corporate weddings. The law lets corporations despoil the environment, but it doesn’t force them. The law lets corporations fire people who have bestowed a lot of human capital because it doesn’t give unorganized labor any rights, but it doesn’t require corporate restructuring. The bad results result from market pressures.

And that leaves me in a state of disquiet as I put down the book. Corporate law is endlessly flexible. It takes national political economies as it finds them and makes adjustments necessary for widget production in particular national contexts. But can we look to it jumpstart political economic change? I doubt it.

Cite as: Bill Bratton, Surmounting the Control Paradigm, JOTWELL (December 1, 2014) (reviewing Colin Mayer, Firm Commitment: Why the Corporation is Failing Us and How to Restore Trust in It, Oxford University Press (2013)), http://corp.jotwell.com/surmounting-the-control-paradigm/.
 
 

Exhausting Regulatory Arbitrage

Annelise Riles, Managing Regulatory Arbitrage: A Conflict of Laws Approach, 47 Cornell Int'l. L.J. 63 (2014).

A recent gathering of regulators opened with a round of congratulations: bailouts were history, bail-ins were on the march, and victory was in sight, just as long as the assembled continued to speak with one voice and kept their bankers well-clear of the public trough. Moments later, it became clear that delegates from continental Europe were marching in different directions, while delegates from certain Nordic and African countries wanted no part of the march. The U.S. and the U.K. held the line, and the meeting closed on a cheerful note, with renewed pledges of regulatory unity.

It is fashionable to criticize regulatory harmonization as hopeless, pointless and potentially harmful. Yet harmonization continues to dominate regulation of international finance in good part because it feels like the obvious answer to two problems: regulatory competition and regulatory arbitrage. Scholarly criticism of harmonization tends to focus on competition. Annelise Riles’ liberating article shows why harmonization loses to arbitrage, and offers an intriguing alternative.

At the outset she revisits definitions. Regulatory arbitrage is a strategy for managing legal difference: by “locating” an activity in one corner of the market rather than another, the arbitrageur gets the same economic result at a lower regulatory cost. Arbitrage is a problem for the regulator when it puts the activity beyond his reach, but leaves him stuck with its effects.1 The fix seems obvious: ending difference ends arbitrage. Enter regulatory harmonization.

For Riles, harmonization and arbitrage are analogs and competitors, since both try to overcome difference. Harmonization starts the race at a big disadvantage because it requires coordination at home and abroad (a regulators’ cartel), and must contend with local politics. The arbitrageur is better off alone; borrowing a phrase from another part of the article, she is working “bottom-up.”

Governments too can fight difference alone—hegemony can displace harmonization—but they are too cheap, too weak, or too squeamish to do it. This follows from Riles’ discussion of harmonization as North Atlantic law-making, a formal convergence subverted in local practice. Inept harmonization is better than hegemony, but it is haphazard and undemocratic. When states commit to harmonize, they give up a “vocabulary” of difference that should be used to articulate local and functional aspirations. Differences “worth fighting for” become unspeakable. Here too, the arbitrageur is unburdened by the public’s constraint: while regulators profess harmony, she is free to exploit difference.

While harmonization fumbles, national courts treat global finance as a local law problem—and feed regulatory arbitrage. They describe financial activity as in-or-out, onshore or offshore, regulated or shadow. In Riles’ example, Morrison v. Nat’l Austl. Bank, U.S. courts apply U.S. law to block regulation by the United States, but also to preempt regulation altogether—they project power to create a regulatory vacuum.2 The field is clear for the arbitrageur.

Riles’ contribution addresses the combined failure of the regulators and the courts. The former paper over national differences; the latter ignore them. She would restore the vocabulary of difference using weedy, elaborate Conflict of Laws doctrines. The result would be a mode of authoritative decision-making that is transnational from the start, but also both structured and dynamic.

Knowing nothing about Conflicts, I found two arguments most startling for contemporary regulation. First, there is no vacuum. Problems of “regulatory perimeter” and shadow finance give way to problems of competing authority and competing laws. There is no offshore, just iterating choices among multiple onshores, with the burden of proving applicable law on the party resisting regulation. This goes against the textbook presumption that governments should stay out of the market, echoes Katharina Pistor’s vision of constructed markets, and adds technique.

Second, I was drawn to the capacity for slicing and iteration in Riles’ description of Conflicts reasoning. In the last part of the article, she unpacks a barely-hypothetical transaction involving a U.S. investor and a French employee at a London branch of a U.S. firm, under an English-law contract. The investor claims fraud in New York. For every aspect of the dispute, the court can (must) engage in thick contextual analysis to determine the scope of its own authority and, separately, applicable law, based on competing interests of different jurisdictions. No single factor—not “location,” not nationality, not party autonomy embedded in contractual choice of law—forecloses inquiry into compelling values.

The result is a problem for regulatory arbitrage, because the law applicable to the activity emerges in a thick substantive inquiry designed to go behind formal attributes and test the multiple values and interests at stake. This feels immensely unsettling to a transactional lawyer, but that may well be the point. Designing around regulation becomes expensive and exhausting, more trouble than it’s worth.

This is an exciting and hopeful insight, which could take many different paths in future work. The analysis is expressly meant to go beyond judicial reasoning, although examples in this article focus on the courts. Regulatory applications, to be explored in a promised sequel, could recast debates about home-host tensions, substituted compliance, and cross-border resolution. Perhaps more importantly, the erstwhile harmonizers would recover a platform for asserting difference without projecting distrust or defeat. A different project could spin out transactional implications: how should contract drafters and deal designers work in a radically dynamic regulatory regime implied by Riles’ argument?

Part of me wishes the article would invest less in sounding pragmatic. Conflict of Laws has deep roots in multiple jurisdictions, but this is an ambitious way of thinking Conflicts in a new context. Deploying Conflicts reasoning against arbitrage would not require new statutes or compacts, but it would require courts, legislators, and regulators committed to formal stability to embrace disruption—and a lot more work. The U.S. Supreme Court’s choice of nineteenth-century Conflicts reasoning in Morrison is not by default. I am also less sanguine about the “bottom-up” inclusive potential of Conflicts. The rules would let small states, people, groups and firms argue about competing values directly, but the voices most likely to percolate from the bottom up are already well-heard in global finance. Meaningful participation would take more institutional work—perhaps for another sequel.

Riles offers a rich frame for talking about difference in global finance. It opens a research agenda, and feels “doable” at multiple levels of ambition. Thinking of conflict as a mode of regulatory cooperation is a relief. Let the arbitrageur worry about harmony.



  1. It also distorts capital allocation and diverts revenues. []
  2. Consider similarities with recent prosecutions of French and Swiss banks for U.S. sanctions running and helping U.S. tax evasion. Here too, one country’s law occupies the field to the exclusion of others. Pending harmonization, U.S., French and Swiss authorities negotiate competing interests behind the scenes. []
Cite as: Anna Gelpern, Exhausting Regulatory Arbitrage, JOTWELL (October 29, 2014) (reviewing Annelise Riles, Managing Regulatory Arbitrage: A Conflict of Laws Approach, 47 Cornell Int'l. L.J. 63 (2014)), http://corp.jotwell.com/exhausting-regulatory-arbitrage/.
 
 

Corporate Privacy

Elizabeth Pollman, A Corporate Right to Privacy, 99 Minn. L. Rev. (forthcoming, 2014) available at SSRN.

Professor Elizabeth Pollman explores the validity and scope of a constitutional right to privacy for corporations in a thought-provoking forthcoming article, A Corporate Right to Privacy. In light of the discussions and debates about the rights of corporations surrounding the Supreme Court’s recent Hobby Lobby decision, the article provides an insightful perspective for thinking about the rights and limitations of constitutional protections for corporations, in particular those relating to the right to privacy.

The article is methodically structured and carefully presented for the reader. Pollman states her measured, core argument early in the article:

This Article argues that corporations hold rights derivatively, to vindicate the rights of natural persons associated with or affected by the corporation. Accordingly, most corporations in most circumstances should not have a constitutional right to privacy….Yet because corporations are not monolithic, but rather exist along an associational spectrum, this Article also highlights that some nonprofit and private corporations could present a stronger claim given their varying purposes and dynamics, particularly in social, political, and religious realms.

Pollman, then, deftly reviews decades of federal and state law relating to corporate privacy, explains her derivative approach for adjudicating corporate constitutional rights, and closes by applying that derivative approach to the right to privacy. The writing in the article is lucid, and the analysis is nuanced. The article recognizes the complexities and sensitivities of examining issues at the intersection of privacy and corporations. It avoids bold pronouncements and omniscient schemes by being mindful of the diversity of considerations relating to privacy and corporations.

In reading the article, one would likely find much of her core argument persuasive, and hints of the beginnings of new lines of inquiries. How does one systemically consider corporate privacy protections when the derivative rights are unclear, or in partial conflict and competition with the direct rights of some corporate stakeholders? What happens when corporations are used as alternative means towards constitutional protections that may otherwise not be as easily accessible? How would the derivative approach to corporate rights work in connection with other constitutional rights relating to corporations? Is the derivative approach stronger and more relevant for some constitutional protections relative to others? The seeds of more complete answers to these questions and others can likely be found in this article, and so can the seeds to related new and important questions for corporate law and society in the coming years.

In reading the article, one is reminded that corporations are legal fictions used to manifest the efforts and capital of the people who constitute them; that they are as complex and diverse as the people who form them, and that many corporate constitutional protections are derived from the constitutional protections of the people behind them. As such, when one deliberates about the depth and breadth of corporate constitutional rights, as Pollman has skillfully done in her article, one is frequently deliberating about the depth and breadth of their own rights.

Cite as: Tom C.W. Lin, Corporate Privacy, JOTWELL (September 29, 2014) (reviewing Elizabeth Pollman, A Corporate Right to Privacy, 99 Minn. L. Rev. (forthcoming, 2014) available at SSRN), http://corp.jotwell.com/corporate-privacy/.
 
 

The Market For “Charlatans”

Alvaro Sandroni, At Least Do No Harm: The Use of Scarce Data, 6 Am. Econ. J.: Microecon. 1 (2014).

Corporate lawyers and their clients routinely hire experts to deliver probabilistic forecasts. For instance, they hire credit rating agencies to deliver credit ratings, which effectively are probabilistic forecasts of credit default events. They also hire experts to deliver probabilistic forecasts of economic, legal, and political events, and even weather events. In hiring an expert, however, they face two distinct problems. The first is a moral hazard problem—how to evaluate, or “score,” an expert’s forecasts in a way that incentivizes the expert to honestly report her opinions (and, importantly, does not perversely incentivize the expert to dishonestly report her opinions to game the system). The second is an adverse selection problem—how to distinguish informed experts (genuine experts) from uninformed experts (charlatans).1 The scoring problem was famously solved by Glenn Brier, who proposed a scoring rule that gives the proper incentives.2 The Brier score is essentially the mean squared error of the expert’s forecasts over the evaluation sample. Solutions to the “charlatans” problem, however, have proven harder to come by. When it comes to probabilistic forecasts, it turns out that it is difficult to devise ex ante tests to screen informed experts from uninformed experts. Basically, the difficulty is that a test which is designed to pass a genuine expert with high probability can also be passed by a strategic charlatan with high probability.3 And ex post warranties are generally not effective.4

In a recent article, Alvaro Sandroni proposes a novel contractual solution to the charlatans problem. More specifically, Sandroni shows that it is possible to write a contract that incentivizes a genuine expert to honesty report her informed opinion and, at the same time, incentivizes a charlatan to “do no harm,” i.e., not report a misleading, uninformed opinion. What’s more, the contract is simple and enforceable, as it makes the expert’s fee contingent on two observable and verifiable facts: the expert’s opinion and the outcome of the event. That said, the contract’s ability to provide the correct incentives depends on a key assumption about the behavior of charlatans, which may or may not hold in reality.

The following example illuminates Sandroni’s elegant and important result.

Alcoa seeks expert advice on the probability that the Internal Revenue Service (IRS) will disallow a deduction on its income tax return. Alcoa has a prior belief about the true probability, but it wants an expert opinion. That is, Alcoa wishes to hire an expert to report her opinion about the true probability.

Alcoa knows that there are two types of experts out there—informed experts (genuine experts), who know the true probability that the IRS will disallow the deduction, and uninformed experts (charlatans), who do not. However, Alcoa cannot distinguish between genuine experts and charlatans. Nevertheless, Alcoa can write a contract that (i) induces the expert to honestly report her opinion if she is informed (so that Alcoa gets the benefit of her expertise if she is a genuine expert), but (ii) induces the expert to report Alcoa’s prior belief if she is uninformed (so that Alcoa is not misled into altering its prior belief by a charlatan). The key assumption is that an informed expert seeks to maximize the expected value of the contract, whereas an uninformed expert seeks to maximize the minimum expected value of the contract. I will say more about the “maxmin” assumption for charlatans later.

The contract makes the expert’s fee contingent on two observable and verifiable facts: (i) her reported opinion and (ii) the eventual outcome (i.e., whether the IRS ultimately disallows Alcoa’s deduction). Specifically, the contract provides that the expert’s fee is the sum of two components: (i) a fixed component and (ii) a contingent component equal to the difference between (a) the Brier score of Alcoa’s prior belief and (b) the Brier score of the expert’s reported opinion.

With this fee structure, the contract provides the correct incentives to genuine experts and charlatans.

First, the expected value of the contract is maximized when the expert reports the true probability. This is because reporting the true probability maximizes the Brier score of the expert’s reported opinion, and because the other parts of the expert’s fee—the fixed component and the Brier score of Alcoa’s prior belief—do not vary with the expert’s report. Thus, the contract incentivizes a genuine expert, who knows the true probability, to honestly report her informed opinion.

Second, the minimum expected value of the contract is maximized when the expert reports Alcoa’s prior belief. If the expert reports Alcoa’s prior belief, the contingent component of the expert’s fee equals zero, and the value of the contract just equals the fixed component. However, if the expert reports anything else, the minimum expected value of the contract is less than the fixed component. This is because in the worst-case scenario—essentially, when the expert’s reported opinion is farther than Alcoa’s prior belief from the true probability—the expected value of the contingent component is negative. This is the key insight behind Sandroni’s result. Hence, the contract incentivizes a charlatan, who does not know the true probability, to “do no harm” by simply reporting back Alcoa’s prior belief.

Of course, Sandroni proves the result at a higher level of abstraction in a more general framework. Importantly, he proves that the result holds for probability distributions over any finite set of outcomes (not just binary outcomes) and for any proper scoring rule (not just the Brier score).

Perhaps the strongest assumption underlying Sandroni’s result is the maxmin assumption for charlatans—i.e., the assumption that an uninformed expert seeks to maximize the minimum expected value of the contract—which is tantamount to extreme risk aversion in an expected utility framework.5 It must be said, however, that the maxmin criterion is a deeply rooted idea in decision theory. Abraham Wald developed it as a solution of a statistical decision problem when a prior probability distribution is unknown.6 John Rawls invoked it as part of a normative theory of justice.7 Itzhak Gilboa and David Schmeidler proposed it as a model of choice under uncertainty when the decision maker is uncertainty averse.8 In the end, I tend to agree with Kevin Bryan, who had this to say about the maxmin assumption in a blog post about Sandroni’s article: “I wouldn’t worry too much about the [maxmin] assumption, since it makes quite a bit of sense as a utility function for a charlatan that must make a decision what to announce under a complete veil of ignorance about nature’s true distribution.”



  1. This is a version of the famous “lemons” problem. George A. Akerlof,The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ. 488 (1970). []
  2. Glenn W. Brier, Verification of Forecasts Expressed in Terms of Probability, 78 Monthly Weather Rev. 1 (1950). []
  3. See Wojciech Olszewski, Calibration and Expert Testing, in Handbook of Game Theory, Volume 4 (Peyton Young & Shmuel Zamir eds., forthcoming 2014). []
  4. See Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549, 597 (1984). After all, how do you prove that a (non-degenerate) probabilistic forecast was incorrect? []
  5. See John Rawls, Some Reasons for the Maximin Criterion, 64 Am. Econ. Rev. 141, 143 (1974), citing Kenneth J. Arrow, Some Ordinalist-Utilitarian Notes on Rawls’s Theory of Justice, 70 J. Phil. 245, 256-257 (1973). []
  6. Abraham Wald, Statistical Decision Functions (1950). []
  7. John Rawls, A Theory of Justice (1971). []
  8. Itzhak Gilboa & David Schmeidler, Maxmin Expected Utility with Non-Unique Prior, 18 J. Mathematical Econ. 141 (1989). []
Cite as: Joshua C. Teitelbaum, The Market For “Charlatans”, JOTWELL (August 15, 2014) (reviewing Alvaro Sandroni, At Least Do No Harm: The Use of Scarce Data, 6 Am. Econ. J.: Microecon. 1 (2014)), http://corp.jotwell.com/the-market-for-charlatans/.
 
 

A New Theory of Insider Trading Law

Sung Hui Kim of the UCLA School of Law has developed a bold new theory of insider trading that is well worth reading. In The Last Temptation of Congress: Legislator Insider Trading and the Fiduciary Norm Against Corruption, Kim lays the foundation of her new theory, which she expands in Insider Trading as Private Corruption.

In arguing that members of Congress are fiduciaries for purposes of insider trading law, Kim joins a number of others scholars who have argued for the imposition of fiduciary duties on government officials. See, e.g., Evan Fox-Decent, Sovereignty’s Promise: The State as Fiduciary (2011); Ethan J. Leib et al., A Fiduciary Theory of Judging, 101 Calif. L. Rev. (2013); D. Theodore Rave, Politicians as Fiduciaries, 126 Harv. L. Rev. 671 (2013); Evan J. Criddle, Fiduciary Administration: Rethinking Popular Representation in Agency Rulemaking, 88 Tex. L. Rev. 441 (2010). I come to this literature as a skeptical reader. Having written extensively on fiduciary law, I am wary of scholarship that purports to extend fiduciary analysis into new domains, stretching the fiduciary concept beyond its analytical boundaries. In Last Temptation, therefore, I prepared myself for an arduous slog when I read that Professor Kim was arguing that the “majority view”—that “members of Congress are fiduciaries to no one” (P. 849)—was wrong (P. 852).

My concerns were heightened when I saw that Professor Kim proposed to begin her analysis through analogy to established fiduciary relationships. (P. 870.) Although Deborah DeMott, one of the leading scholars of fiduciary law, argues that this is the method employed by courts (and implies that the method would, therefore, be appropriate for commentators), analogical reasoning has limited value without an underlying theory of fiduciary relationships. I come from a group of scholars who contend that fiduciary duties arise from the structure of relationships, and this analysis does not depend heavily on analogical reasoning. See D. Gordon Smith, The Critical Resource Theory of Fiduciary Duty, 55 Vand. L. Rev. 1399 (2002); Larry E. Ribstein, Are Partners Fiduciaries, 2005 U. Ill. L. Rev. 209. Thus, I found Professor Kim’s analysis in Part II “unsatisfyingly thin,” (P. 853) as she predicted.

Of course, Professor Kim was not convinced by her own metaphors. She recognized the limitations of analogical reasoning and used that section of her paper to set up a more persuasive analysis grounded in “the underlying policy or purpose that animates fiduciary law.” (P. 893.) In the most important and original section of the paper, Professor Kim argues that “one core purpose of fiduciary law is anti-corruption.” (P. 903.) Relying on the “rule against secret profits” (P. 904), she links corruption in the public sector to fiduciary principles for purposes of federal insider trading law. The analysis in this part of the paper is nuanced, original, and insightful. Impressive.

As much as I ended up liking Last Temptation, I was even more impressed with Insider Trading as Private Corruption. In this piece, Professor Kim builds on her incomplete theorization of corruption in Last Temptation, proposing a “new theory of insider trading law” based on anti-corruption. (P. 932.) This is an ambitious and exciting piece of scholarship, attempting to bring more conceptual coherence to a notoriously challenging area of law.

Professor Kim nicely reveals the shortcomings of existing theories and readily concedes some shortcomings in her own theory. (I chuckled a bit, but appreciated her confidence in suggesting that “the sites where corruption theory diverges from the received doctrine constitute areas ripe for doctrinal reform.” (P. 935.).)

Her taxonomy of the costs of corruption is especially significant as a framework for analysis. (P. 961-967.) Professor Kim identifies three categories of costs from corruption. “Temptation Costs” arise when managers allow their decisions about the corporation to be influenced by self-interest, for example, by “push[ing] the firm into riskier projects or manipulat[ing] the timing and content of information release in a manner that will generate more price volatility than otherwise.” (P. 962.) “Distraction Costs” consume managerial time and attention. (P. 964.) And “Legitimacy Costs” may affect securities markets if investors come to view those markets as a “rigged game.” (P. 967.) On the whole, I was convinced by Professor Kim, that a “key benefit of seeing insider trading as private corruption is that it allows us to see the harms of insider trading more generally as the harms of corruption.” (P. 961.)

Insider trading is a nice place to start the development of the corruption theory, but I hope Kim does not end her investigations there. This is a nice framework for thinking about extensions of fiduciary law into new fields.

Cite as: D. Gordon Smith, A New Theory of Insider Trading Law, JOTWELL (July 16, 2014) (reviewing Sung Hui Kim, The Last Temptation of Congress: Legislator Insider Trading and the Fiduciary Norm Against Corruption, 98 Cornell L. Rev. 845 (2013). Sung Hui Kim, Insider Trading as Private Corruption, 61 UCLA L. Rev. 928 (2014). ), http://corp.jotwell.com/a-new-theory-of-insider-trading-law/.
 
 

Drama and Consequence in Accounting Standards Choice (Seriously)

The value of interdisciplinary work is on display in this article by two Dutch policy scholars: the subject matter is accounting rules for financial instruments, but it spans public policy and regulation in a way that is also of interest to scholars of law and regulation. (Full disclosure: I am an editor of Regulation & Governance, though I was not involved in this article’s editorial process.)

Mügge and Stellinga discuss the choice between the two main accounting standards (fair value accounting, or FVA, and historical cost accounting, or HCA), across three policy-making moments between 1997 and 2013, in terms of two dominant explanatory theories for policy change—neither of which turns out to be convincing. What emerges is a sense of how accounting regulators, specifically the EU’s Accounting and Regulatory Committee (ARC), put in place unstable sets of accounting standards for financial instruments that were neither exactly what banks wanted, nor what the International Accounting Standards Board (IASB) as standard-setter wanted. Nor is this simply a case of a regulator ‘splitting the baby’ between competing interest groups.

FVA is a useful accounting method because it can produce the best estimate of an asset’s present ‘value’. In accounting terms, assets do not have an inherent, fixed value beyond what the market’s current, aggregated preferences generate, and that is what FVA records. On the other hand, FVA can be volatile and have procyclical effects, can exacerbate herding behavior, and can be highly subjective in valuing illiquid assets. HCA’s advantages are the flip side of FVA’s: HCA is effective in tempering market volatility and tamping down herding, since assets are recorded at historical acquisition cost. However, HCA can also imperceptibly allow vulnerability and risk to build up. This can produce distrust, and is especially unhelpful with respect to contingent, hard-to-price instruments such as derivatives. Across time, as the authors show, one accounting standard has often been the solution to the other’s problems.

The authors look at EU accounting standard policy through three time periods: the Full Fair Value proposal in 1997-2001, the IAS 39 controversies from 2002-2005, and the financial crisis and IFRS 9 from 2008-2013. Throughout, the IASB as standard setter maintained an unambiguous preference for a clear, stringent FVA standard. Banks preferred FVA in good times, but HCA in bad times—that is, they had no consistent accounting standard preference but a clear preference for flexibility and their own autonomy. If an expertise-based causal account had been operating, the IASB would have prevailed in establishing the regulatory standard. If regulatory capture were dictating outcomes, presumably the banks would have prevailed. The result was neither. Instead, the ARC as regulator waffled between FVA and HCA, producing temporary fixes, policy reversals and hybrid positions, and clashing with both banks and standard-setter at different times.

What was ARC doing? Was its response simply incoherent, perhaps because of internecine disagreements? (No, though it might have looked that way sometimes.) Was it pursuing a separate agenda? (Not really.) Banking regulators were unified in their action, but “without a clear and consistent preference for a specific accounting treatment for financial instruments, or for allowing banks to choose one themselves.”

Why could ARC not identify a stable preference for a general rule? Because its preference might change later. Regulators need reliable data to promote fair and efficient capital markets, so FVA is a good method—but not if it actually causes banks to fail. In a crisis, needing to consider systemic safety and soundness, the regulator will avoid loss and side with the banks in favor of HCA. Recognizing this, ARC avoided committing completely to a single standard, while also not giving banks free rein. The result is that accounting standards—ostensibly stable, common concepts—“offer no solid fundament” and “remain temporary fixes.” In this way, the simple but puzzling question of differential accounting treatment over time unspools into a narrative about the drivers of, and tensions within, regulation.

Mügge and Stellinga note that the dynamic they describe is “rooted in the reflexivity of financial markets, in which future expectations, which are translated into valuations, shape the future they seek to describe.” They wonder whether “an apparent ‘lack of progress’ in global financial governance is not solely owed to its global nature, but more importantly to the inherent limits of governing reflexive financial markets.” They make policy recommendations for improving regulation (including a Twin Peaks regulator). Another thing that emerges from their account, however, is a more persistent tension that will bedevil regulation no matter its form: the tension between the stability law provides, and the pragmatic and dynamic capability the modern world seems to demand.

Mügge and Stellinga’s work invites us to think further about why FVA rules are the solution to HCA rules’ problems, and vice versa. It is because ultimately, the problem is temporality, and the difference between FVA and HCA is temporal: the accounting method modifies the moment at which an asset is valued. The relationship between effective regulation and time demands more study. We value good timing in regulation: the Federal Reserve needs to know when to take the punchbowl away (just when the party starts going). After a crisis we want to avoid ‘building another Maginot line’, or ‘closing the barn door after the horse has left’, or engaging in “quack corporate governance” (per Roberta Romano) for the sake of being seen to be doing something. Very often, however, we remain hostage to our times. We like our party, and our punchbowl, even if after a crisis we are struck with hindsight righteousness and, sometimes excessively or ill advisedly, demand a response. Mügge and Stellinga show how in this case, ARC’s regulatory choice has been to fail to commit to one accounting standard for financial instruments, even though this leaves the structure of accounting standards resting on the shifting sands of temporal preference. Given the policy tensions in ARCs’ mandate and its sensitivity to the pros and cons of each accounting method, at least this shows pragmatic attention to trying to do what needs to be done to discharge its mandate. At the times in question, it is not obvious that a single consistent position would have been wiser. All the same, leaving the choice of accounting standards in a state of perpetual uncertainty seems a high price to pay.

Cite as: Cristie Ford, Drama and Consequence in Accounting Standards Choice (Seriously), JOTWELL (June 20, 2014) (reviewing Daniel Mügge & Bart Stellinga, The unstable core of global finance: Contingent valuation and governance of international accounting standardsReg. & Governance (forthcoming, 2014)), http://corp.jotwell.com/drama-and-consequence-in-accounting-standards-choice-seriously/.
 
 

New Law School Fields of Study: Compliance and Risk Management

Geoffrey Miller, The Law of Governance, Risk Management, and Compliance (Wolters Kluwer Law & Business (Aspen Casebook Series) 2014).

I would not normally think of a casebook as appropriate for JOTWELL. It is the particular fit between a teacher’s ambitions and the material in the casebook that makes a teacher like the casebook, perhaps even a lot. A good casebook is a shell that the teacher and students can inhabit and learn to carry. It is not a well-formed argument of general applicability, such as would be found in the work that JOTWELL generally applauds.

Yet, in JOTWELL, I commend to your attention Geoffrey Miller’s The Law of Governance, Risk Management, and Compliance. This casebook is a convincing argument that compliance and risk management are fields of study appropriate for legal education. It expands the law school field of corporate governance from its current restricted view, discussing shareholders and boards, to one that encompasses all the actors within and without corporations who have an impact on compliance.

In corporations today, lawyers are in conflict with themselves and others about whether the management of compliance activities is a lawyerly activity. Is teaching and inspecting compliance with the law a job for lawyers? Some lawyers answer “no;” some legal departments are happy to forsake such policing functions, preferring consultative activities. Others believe that the organizational knowledge required for managing compliance goes beyond normal legal skills. And, yet others take a dim view of lawyers as organizational problem-solvers or compliance motivators.

Lawyers are even more leery of getting involved in risk management activities. Despite its increasing prominence as a regulatory device, risk management is associated with metrics and math-phobic lawyers run from it. More sophisticated lawyers worry about the residual risk of non-compliance associated with whatever risk level is chosen. And all have to compete with the accounting consultancies that have made risk management a strategic arena for their growth.

Geoffrey Miller has produced a casebook for those of us who want to prepare our students to be able to practice compliance or operate in the corporate environment of risk management. In a shrinking lawyer marketplace, that is sufficient justification for this book. There are good jobs to be had for those prepared to understand organizational behavior and sources of non-compliance risk. From a law school perspective, Miller’s casebook invents a field. From the corporate job market perspective, it grounds students who can fulfill a present need.

Courses on Business Associations teach corporate governance as an issue of shareholder and board control. Board committees and the duties of a general counsel might get brief mention. But, executives, CFO’s, internal audit, HR, compliance or even non-SEC regulators are not mentioned. Miller’s book sets out a fuller picture of how corporations are governed. And then applies this picture to a series of case studies. Cases concerning information security, regulated products, FCPA, money laundering, sexual harassment, and social responsibility are analyzed. Finally, the book turns to risk assessment, mitigation and transfer.

Miller makes the current self-understanding (ideology) of corporate behavior a subject for study in law school. This book prepares students to work for corporations, not just law firms. But it also is good preparation for those students who obtain law firm jobs, for law firms, after all, give the best service when they understand their clients’ self-understandings. I commend this casebook to you.

Cite as: Robert Rosen, New Law School Fields of Study: Compliance and Risk Management, JOTWELL (May 20, 2014) (reviewing Geoffrey Miller, The Law of Governance, Risk Management, and Compliance (Wolters Kluwer Law & Business (Aspen Casebook Series) 2014)), http://corp.jotwell.com/new-law-school-fields-of-study-compliance-and-risk-management/.
 
 

A Painful Shift from a New Paradigm to Regulatory Reality

Under what conditions do new scientific and technocratic paradigms drive profound policy change? Policymakers and bureaucrats are cognitively bound by, and emotionally attached to, the scientific and technocratic paradigms that guide their daily operations. Consequently, indications that existing policies and regulatory approaches are producing bad or unintended results tend to be ignored over long periods of time. Insofar as such signals are attended to, this is done within the logic of an existing paradigm, thereby resulting in incremental change. Fundamental – third order – policy changes entail a paradigmatic intellectual shift, which delineate an alternative problem definition, and a complementary set of policy tools. Students of policy associate such instances of third order change with Peter Hall’s study of the British Treasury and the Bank of England’s shift from Keynesian economics to monetarism in late 1970s. As shown in Hall’s study, this policy makeover was enabled by a coupling between Margaret Thatcher’s political will and the American-driven intellectual development of monetarism as an alternative to Keynesianism.

Still, Andrew Baker’s study shows that while a paradigmatic intellectual shift may be a necessary condition, as suggested by Hall, it may still be insufficient for fundamental policy change. Baker suggests that macro-prudential regulation encapsulates, intellectually, a paradigmatic shift in a similar vein to the rise of monetarism and the rejection of Keynesian economics. Pre-crisis financial regulation, as encapsulated in the Basel II standards, was based on the premise of market efficiency. Banks were assumed to have the capacity to assess and manage their capital and liquidity risks, and asset prices together with ratings by credit agencies were assumed to reflect assets’ real values and risks. Consequently, “Greater transparency, more disclosure, and more effective risk management by financial firms based on market prices became the cornerstones for the regulation of ‘efficient markets.” (P. 420). Macro-prudential regulation, by comparison, rejects the premise of efficient markets. Rather, it postulates that asset prices can be driven to extremes, whether upwards or downwards, due to pro-cyclicality (i.e. excessive levels of investment when prices are rising and radical contraction when prices are falling), herding behavior and complex interdependence between financial institutions and transactions. During 2008, this approach, which attracted limited support before the crisis, became the mainstream discourse of international and national financial regulators. By comparison, “Open advocates of rational expectations, new classical thinking, and an efficient markets perspective have been hard to find in financial regulatory networks, since late 2008.” (P. 424-25).

However, insofar as policy tools are concerned, in the five years following the outbreak of the crisis, macro-prudential regulation has produced only incremental change. Specifically, the Basel III accord did not abandon risk-management through Value at Risk models, and their heavy reliance on asset prices (despite the intellectual consensus around the failure of these instruments). Capital adequacy ratios were adjusted upwards, but too a much lesser extent than advocated by macro-prudential theorists’ concerns with system-wide risks. At the same time, macro-prudential instruments, such as counter-cyclical capital buffers (i.e. increasing capital adequacy ratios at times of economic growth and vice versa), were appended to the existing micro-prudential system. Still, even this macro-prudential component of Basel III was rather ambiguous, and involved substantial discretion, reading: “For any given country, this (countercyclical capital) buffer will only be in effect when there is excess credit growth that is resulting in a system wide build-up of risk.” This dilution of macro-prudential regulation in the Basel III standards is further replicated in national contexts. Hence, at this point it is unclear to what extend the new macro-prudential regulatory philosophy will restrain excessive investment and credit provision during economic upturns.

Baker provides multiple explanations for this dilution of macro-prudential regulation. First, because there was so little support for macro-prudential regulation prior to the crisis, there was insufficient practical experience with its implementation. Consequently, the technical details of macro-prudential regulation remained underdeveloped and debated within the expert community. Second, compared with the political will of Thatcher, that drove the shift towards monetarism in the late 1970s, the shift to macro-prudential regulation was a technocratic project that was consequently slow and cautious. Third, and arguably most important, financial regulation is a field with numerous powerful public and private veto players. Private actors were naturally resistant to, and willing to employ heavy lobbying against, any policy change that would constrain their investment strategies. In addition, national regulators were nervous about any implications for their own turf, as well as inclined to protect the international competitiveness of their local financial sectors. Moreover, in the short term of economic downturn and market contraction, requiring banks to substantially increase their capital reserves would have entailed a slower recovery for both banks and the real economy. Hence, even according to a macro-prudential approach this was a bad time for change. All this has resulted in the “layering” of macro-prudential regulation on top of an incrementally modified system of micro-prudential regulation as opposed to transformative change. Yet, Baker predicts that over time, with further experimentation and deliberation within the community of technocrats, and political negotiation at national and international levers, (some form of) macro-prudential regulation will become not only the dominant intellectual approach but also a day-to-day regulatory reality. But then, we should further assume, following Peter Hall (who himself followed Thomas Kuhn), that the next financial-regulation paradigm is already being developed somewhere, waiting to replace macro-prudential regulation.

Cite as: Sharon Gilad, A Painful Shift from a New Paradigm to Regulatory Reality, JOTWELL (April 21, 2014) (reviewing Andrew Baker, The gradual transformation? The incremental dynamics of macro-prudential regulation, 7 Reg. & Governance 417 (2013)), http://corp.jotwell.com/a-painful-shift-from-a-new-paradigm-to-regulatory-reality/.
 
 

What’s Left of Mandatory Shareholder Primacy?

Lyman Johnson & Robert Ricca, The Dwindling of Revlon, Wash. & Lee L. Rev. (forthcoming 2014) available at SSRN.

My colleague Lyman Johnson and his co-author Robert Ricca have written an important new paper on the Delaware Supreme Court’s well known Revlon doctrine.  They make two noteworthy points in their article.  First, they argue that courts have interpreted Revlon‘s scope too narrowly, excluding from its coverage cases that do not actually result in a deal.  Second, they show that in actual practice Revlon is much less important than commentators and lawyers have appreciated.  So, the only Delaware case mandating short-term share price maximization ends up not only having more restricted application than its logic and policy might otherwise appear to require; its limited practical relevance indicates an even weaker doctrinal commitment to shareholder primacy than academics and others realize.

The Delaware Supreme Court decided the Revlon case in 1986, in the midst of a flurry of important rulings necessitated by the explosion in hostile takeover activity.  These cases called on the court to balance its traditional emphasis on the board of directors’ authority and responsibility to determine the corporation’s future against shareholders’ interest in unimpeded access to tender offer premia.  Lurking in the background were broadly held concerns about the social costs of hostile takeovers.  In the event, the court came down on the side of management’s broad (though not unlimited) discretion to deploy defensive measures to block unwelcome hostile tender offers, except in narrow circumstances defined in the Revlon case.  As elaborated in subsequent decisions, Revlon requires that management set aside its own views about what’s best for the corporation and its shareholders and instead seek to obtain the best price reasonably available for the company’s shares.  This duty arises if management initiates an active bidding process that will result in a sale leading to breakup of the company; or, if in response to a bidder’s offer, it abandons its long-term strategy in favor of a transaction that will result in breakup of the company; or, if it approves a transaction that will result in a change in control of the corporation.

It has been broadly assumed that Revlon is important because it mandates that management prioritize short-term share price over competing considerations under defined circumstances.  This is the only exception to the management’s normal fiduciary responsibility to focus on the corporation’s long-term well-being. Further, Revlon mandates heightened judicial scrutiny of management’s efforts to discharge its responsibility and places the burden of proof on them, holding out the prospect of personal liability for failure to perform their duty to accomplish a transaction that maximizes share price.  Here we see a potentially important exception to the normally highly deferential business judgment rule standard of review.

In this article, Johnson and Ricca argue persuasively that it makes no sense that courts apply Revlon only in cases that actually result in a transaction.  The language of the relevant precedents, logic, and policy all suggest that it should also apply to what they call ‘no-deal’ cases, that is, cases in which the board has embarked on a course of action that would have resulted in breakup of the company or change of control but for whatever reason they have failed to close a deal.  The argument here is careful and thorough and worthy of close study, but space does not allow me to summarize it here.  One might respond, though, that all of the situations that trigger Revlon are optional in the sense that a board must choose voluntarily to initiate them.  Arguably, the board ought also to have the freedom to voluntarily change its mind, at least up to a certain point short of an actual transaction.

Of more immediate interest to most readers will probably be Johnson and Ricca’s second point about Revlon‘s limited practical relevance apart from its arguably too narrow application. Soon after the decision, the Delaware legislature added section 102(b)(7) to the state’s corporation law.  This provision permits Delaware companies to absolve directors of money damages liability for breach of the duty of care, and they have routinely accepted the invitation to do so.  Thus, if phrased in terms of breach of the duty of care, Revlon–based claims can only yield equitable relief.  If the claim is bad faith, exculpation provisions would not apply, but the Delaware Supreme Court has set that bar quite high, stating that recovery would only be available upon proof that ‘directors utterly failed to attempt to obtain the best sale price.  Even that very demanding hurdle might be overcome in some cases, however, as in Revlon itself or in Paramount v. QVC where the boards deliberately did all they could to thwart potentially higher priced offers

Questions of potential bad faith generally are not litigated, however, because the inevitable lawsuits that virtually all transactions potentially subject to Revlon generate typically seek preliminary injunctions prior to closing rather than money damages.  Johnson and Ricca show that these claims virtually never succeed if litigated.  Plaintiffs obtained relief in only one case filed between 2008 and 2013.  Meanwhile, settlements typically mandate nothing more than additional disclosure.  Add to this the absence of judgments after trial imposing post-closing equitable relief or money damages based on bad faith and the authors’ conclusion is readily apparent: The Revlon doctrine today may retain a certain cosmetic luster, but it lacks remedial clout.

Oddly, this truth seems lost on the lawyers most directly involved in this area of the law.  Once Revlon is triggered, corporate counsel continue to advise compliance with its apparently strict insistence on following procedures and incorporating deal terms designed to get the best price reasonably available, even though the liability risk is in fact trivial.  Plaintiffs’ lawyers continue to challenge virtually every transaction, apparently expecting attorneys’ fees awards despite the very dim prospects of achieving a favorable judgment or a settlement including a monetary component.

Of potentially more far-reaching importance are the implications to be drawn from an accurate understanding of Revlon‘s limited real-world significance.  Revlon defines the sole circumstances under which management of a Delaware corporation is required to maximize short-term share price. 

As noted, these circumstances are optional in the sense that they require voluntarily assumed undertakings; a corporation cannot be forced unwillingly into ‘the Revlon mode.’ Further, as Johnson and Ricca note, the courts have not extended Revlon as broadly as they might and, arguably, should, exempting ‘no-deal’ scenarios from scrutiny.  And, even where it actually applies, Revlon has virtually no remedial significance.  In light of all this, can it seriously be claimed that Delaware corporate law is committed to shareholder primacy even in this isolated area?

Cite as: David Millon, What’s Left of Mandatory Shareholder Primacy?, JOTWELL (March 18, 2014) (reviewing Lyman Johnson & Robert Ricca, The Dwindling of Revlon, Wash. & Lee L. Rev. (forthcoming 2014) available at SSRN), http://corp.jotwell.com/whats-left-of-mandatory-shareholder-primacy/.