Why Directors Don’t Direct

Adam Badawi, Influence Costs and the Scope of Board Authority, 39 Iowa J. Corp. L. 675 (2014), available at SSRN.

Over four score years ago, William O. Douglas told us that directors don’t direct. Since then, there have been multiple attempts to enable directors to direct the corporations they nominally manage, often by proposing or mandating changes in the composition of the board. Directors’ backgrounds, biases, opportunism and group behaviors have been diagnosed as both the cause and cure to the problem of director inaction.

Rather than examining directors, Adam Badawi shifts attention to those outside the board to explain why it is in the interest of the business that directors don’t direct. His focus is not on coalitions within the board, but on lobbying of the board by others in the corporation. So that these other interests don’t spend their time attempting to influence the board (and instead concentrate on activities more profitable to the business), it is essential that boards exercise little of the authority they possess. By delegating authority to management, boards constrain the investment management makes in lobbying the board.

As Badawi makes clear, restricting board activity may restrict the board’s abilities to reduce the agency costs occasioned by the separation of ownership and control. His focus is on the trade-offs. He considers, for example, the displacement of inside directors by outside ones. The gains in better monitoring of agency costs, Badawi argues, come with increases in lobbying costs, especially those imposed on the firm by the former directors. (P. 678.) As employees have non-diversifiable firm-specific capital investments, they will actively lobby the board. This lobbying may take various forms from massaging the information that the board receives to overt politicking. Because they have strong interests in the outcome, employees will impose influence costs on the firm when the board seeks to exercise its authority, “[t]o put it another way, the drag that lobbying can exert on a firm increases with every additional decision the board makes.” (P. 687.)

The trade-offs between influence costs and agency costs will be business and issue specific. Hence, Badawi argues, the deference of the business judgment rule to director exercise of their authority reflects fear of imposing influence costs on the firm. (P. 679.) As board oversight increases, agency costs might decrease, but the organizational drag of influence costs might increase. The appropriate trade-off, how board decision-making is structured, is contextual and difficult to make, perhaps especially by the board. Hence, the judicial hands-off policy is the proper default option. In an M.I.T. dissertation, Michael Powell has found a convex shape to the costs of lobbying. (P. 684.) Hence, a rule of law that required more board governance – such as a weakening of the business judgment rule – would “escalate very quickly” influence costs “in a way that is quite difficult for a court to observe.” (P. 708.)

Badawi’s account also explains why firms sometimes use outside law firms and independent consultants. Information that the board gets internally should be presumed to be influenced by the strong interests of firm employees. They may be knowledgeable, but they are interested. So, in an acquisition, a firm is likely to seek the independent but less knowledgeable opinion about whether the target is or is not a good fit for the firm. (P. 690) (even without Van Gorkom).

Badawi doesn’t claim that influence costs are the only reason why directors don’t direct (P. 692). But it is a breath of fresh air to find an article that neatly illuminates that question and that doesn’t impugn directors. One mark of a very good article article is the reaction, “of course.” And, that was my initial reaction to this article. I then thought that it is shocking that it hadn’t already been written. Badawi has his finger on something, and analyzes it beautifully. It should be much cited.

I hope this article also stimulates empirical work. If the CEO is Chairperson of the Board, what lobbying takes place? Does that influence the range of activities that the board undertakes? Do boards with CEO’s as Chairperson direct more than those without? When the General Counsel (as Board Secretary) sets the agenda, how is the legal department lobbied? There are, I believe, many more studies of intra-board politics than of firm-board politics. Badawi challenges us to undertake such research, and we should be grateful for that stimulus.

Cite as: Robert Rosen, Why Directors Don’t Direct, JOTWELL (April 1, 2016) (reviewing Adam Badawi, Influence Costs and the Scope of Board Authority, 39 Iowa J. Corp. L. 675 (2014), available at SSRN), http://corp.jotwell.com/why-directors-dont-direct/.

Constituency Directors, Loyalty, and the Corporate Objective

Martin Gelter & Geneviève Helleringer, Lift Not the Painted Veil! To Whom Are Directors’ Duties Really Owed?, 2015 U. Ill. L. Rev. 1069 (2015).

Theories of corporate law and governance that purport to explain the nature of the corporate entity, the legitimate objective of corporate decision-making, and/or the balance of corporate power have proliferated over recent decades, and the debates prompting them show no signs of abating. Some accounts place the shareholders’ interests at the core of the enterprise, while others present more embracing conceptions requiring (or at least permitting) regard for other “stakeholders” such as employees and creditors. Similarly, some accounts identify shareholders as the font of legitimate corporate power, while others present more board-centric conceptions. Adding to the complexity, various theories combine differing perspectives on the corporate objective and corporate power in differing ways, often rooting them in irreconcilable conceptions of what the corporate entity itself fundamentally is. As time passes, the arc of corporate theory would appear to bend toward fragmentation rather than closure.

In the article cited above, Martin Gelter and Geneviève Helleringer illuminate these issues from a fascinating doctrinal perspective, exploring what the persistence of so-called “constituency directors” – placed on the board by a particular individual or institution – reveals about the nature and defining objective of corporate decision-making. Gelter and Helleringer bring to the task not only deep engagement with the scholarly literature in these areas, but also considerable comparative and interdisciplinary sophistication. Drawing upon a broad range of examples from U.S., U.K., and Continental European corporate legal systems, they observe a “fundamental contradiction” manifesting itself in all of them – “the tension between the uniformity of directors’ duties and the heterogeneity of directors themselves.” Specifically, they identify an apparent “paradox” in permitting “directors’ nomination rules linked to specific constituencies” while at the same time imposing “heterogeneity-blind duties.” Building on their descriptive account of illustrative doctrinal structures, Gelter and Helleringer assess them against prevailing formulations of the corporate objective, social scientific insights, and the available empirical evidence, concluding with a normative case for reform. Their product is informative, insightful, and a pleasure to read.

Whether the director in question is a venture capital investor’s nominee, increasingly common in the United States; an employee representative appointed under a Continental European codetermination system; a minority shareholder representative; or even a government representative (with which even the United States has some recent experience under TARP), directors’ duties remain undifferentiated. “In spite of the heterogeneity of directors between and within countries,” Gelter and Helleringer find, “all major jurisdictions, of which we are aware, developed a strongly uniform duty of loyalty for all directors.” While such issues have historically loomed larger elsewhere, Gelter and Helleringer rightly observe that their salience in the United States has increased as defined contribution pensions and greater institutional dominance have produced a more active and heterogeneous investor base.

In such situations, the potential for cognitive dissonance blurring into outright conflict of interest is obvious and acute, and structures permitting constituency directors have remained workable only because of another (perhaps ironic) commonality that all such jurisdictions share, which is that “the purported objective of fiduciary duty – however formulated in theory – is not clearly defined at all.” Directors are instructed to pursue the best interests of “the company” or “the corporation,” whatever that means. Sometimes there is a simultaneous nod toward the interests of the shareholders, an instruction that effectively remains unenforceable due to structures substantially insulating board discretion (e.g. the business judgment rule). Accordingly, while clear self-dealing may be aggressively policed, more general and pervasive conflicts pertaining to business policy typically will not. For lack of any coherent substantive definition, the corporate objective effectively has been “procedurally” defined through board appointment rules – and in such cases the outcome will, as an empirical matter, often “look more like negotiation between different groups than deliberation for a common purpose.”

A particularly important question reflecting these dynamics, Gelter and Helleringer suggest, is whether constituency directors ought to be permitted to share nonpublic information with the entity appointing them. While directors “are typically subject to a duty of confidentiality that prohibits them from sharing nonpublic information from the company with their sponsor,” Gelter and Helleringer argue in their normative discussion that “permitting firms to opt out of confidentiality” may be desirable – at least where the board appointment structure effectively amounts to a negotiated resolution to long-term contracting problems among various stakeholders.

This intriguing line of normative argument could be refined and taken further, and perhaps will be in future work. Regardless, Gelter and Helleringer’s article is a rewarding read, offering a rigorous, nuanced, and insightful analysis of constituency directors and their implications for prevailing conceptions of the duty of loyalty and the corporate objective.

Cite as: Christopher M. Bruner, Constituency Directors, Loyalty, and the Corporate Objective, JOTWELL (March 1, 2016) (reviewing Martin Gelter & Geneviève Helleringer, Lift Not the Painted Veil! To Whom Are Directors’ Duties Really Owed?, 2015 U. Ill. L. Rev. 1069 (2015)), http://corp.jotwell.com/constituency-directors-loyalty-and-the-corporate-objective/.

Corporate Intent and Corporate Crime: A Matter of Inference

Mihailis Evangelos Diamantis, Corporate Criminal Minds, 91 Notre Dame L. Rev. ___ (forthcoming 2016), available at SSRN.

The Yates Memo emphasizes the need to fight corporate crime by imposing criminal liability on individual criminal perpetrators. But critiques of corporate deferred prosecution agreements and cascades of examples of corporate criminality involving crimes such as bribery, manipulation, tax evasion and sanctions-busting raise questions about criminal liability of corporations as well as the liability of individual wrongdoers. Whether sanctioning individuals or the corporations they work for would be more effective in achieving deterrence or vindicating society’s interest in ensuring legal compliance and sanctioning legal violations is an empirical question. But improving the rules about corporate criminality does not require abandoning efforts to sanction individual criminality.

The problem Mihailis Diamantis addresses in this article is not a new one: corporations may be subject to civil and criminal liability for their acts, but assigning criminal liability to a corporation depends on an “antiquated gimmick—respondeat superior,” which focuses on attribution of employees’ intent to the corporation, rather than on any real theory. Diamantis states that respondeat superior results in assigning criminal liability to corporations where the criminal acts resulted from the actions of a few rogue employees, and insulating the corporation from criminal liability inappropriately merely because no single employee has the requisite mens rea. He argues that whereas respondeat superior may have made sense as the basis for the attribution of mens rea in the context of small corporations it makes no sense in the context of large complex modern business enterprises. Corporate personhood may be a legal fiction, but it is one to which the law is committed, and therefore it is necessary to be able to identify the mental state of these fictional persons.

The solution Diamantis offers is a “new theory of corporate mens rea that could be plugged into the current framework of criminal liability” rather than a radical overhaul of the criminal law.

Diamantis concedes that he is not the first to acknowledge the deficiencies of respondeat superior or to suggest improvements (for example approaches that rely on ideas of an inner circle, or collective knowledge, or corporate ethos). Diamantis’ proposed solution involves “further anthropomorphizing corporations in the eyes of the law, and adjudicating their mental states just as courts do those of natural persons— inference to the best explanation from acts and surrounding circumstances.” The problem of working out what was in the mind of the corporation is not so different from the problem of identifying the mental state of a natural person. We should infer intent from action. The argument is elegant in its simplicity.

Diamantis says that his solution to the corporate mens rea problem “harmonizes with recent discoveries in cognitive science and social psychology about how people actually assess the blameworthiness of groups like corporations.” People behave as though corporations are real, rather than merely fictional, entities and are willing to attribute blame to them in much the same way that they attribute blame to individuals. Why, then, would the law behave differently?

Cite as: Caroline Bradley, Corporate Intent and Corporate Crime: A Matter of Inference, JOTWELL (February 3, 2016) (reviewing Mihailis Evangelos Diamantis, Corporate Criminal Minds, 91 Notre Dame L. Rev. ___ (forthcoming 2016), available at SSRN), http://corp.jotwell.com/corporate-intent-and-corporate-crime-a-matter-of-inference/.

Contracting for Ethical Banking

Claire A. Hill & Richard W. Painter, Better Bankers, Better Banks (The University of Chicago Press, 2015).

Claire Hill and Richard Painter’s new book is the latest addition to their long line of work on the complex interaction between law, economics, culture, and individual behavior in the fast-moving world of investment banking. In this exceptionally well-written book, Hill & Painter target what they view as the fundamental problem with today’s Wall Street: the fact that bankers (a term that denotes mainly investment bankers and other securities industry professionals) are allowed to behave in socially harmful ways, without suffering meaningful personal consequences.  Alas, the authors don’t need to try very hard to convince us why this topic is both timely and important. What seems to be a never-ending string of scandals involving large financial institutions rigging prices, misleading customers, and helping clients cheat tax authorities and creditors provides plenty of evidence to that effect. If, after all these ugly revelations, you still trust bankers’ assurances that they are “doing God’s work,” you haven’t been paying attention.

In the book, Hill & Painter explain why, in recent decades, Wall Street bankers so consistently failed the public whose money they purport to manage. While not necessarily breaking new ground in this well-trotted area, the book does a great job of telling a rather impressively comprehensive story of how, in the course of the last few decades, investment bankers gradually abandoned their professional ethos in favor of purely self-serving pursuit of personal profit that is at the core of today’s culture of “irresponsible banking.” Hill & Painter trace the transformative changes in the business model of modern investment banking in the context of the increasingly competitive, globalized, computerized, and impersonal marketplace. One of the central themes here is the loss of bankers’ unlimited personal liability as a result of mass conversions of investment banking firms from partnerships to publicly traded corporations. Hill & Painter masterfully depict how this seemingly innocuous change reshaped the structure and culture of Wall Street from the 1970s on. To this broad-brush picture, they add nuance by dissecting some of the psychological factors driving individual investment bankers to disregard society’s interests and gamble with other people’s money. I found that part of the book particularly enjoyable and insightful.

What makes the book an even more worthwhile read, however, is the authors’ proposed solution to the problem of irresponsible banking. Hill & Painter preface their proposal by stating that an effective solution to problematic behavior in the financial industry must target not only monetary incentives – the focus of many proposed reforms – but also the underlying industry values. Importantly, the authors are skeptical about the efficacy of law as the key engine of an industry-wide normative shift. To them, changes in banks’ business practices mandated by regulation alone are bound to miss the mark, largely because regulators are ill-equipped to stay ahead of the misbehaving bankers. So, if it’s not the law and its agents, then what or who could possibly transform Wall Street’s culture?

The book’s answer to this question is elegant in its simplicity. Hill & Painter propose that investment banks – the corporate entities whose coffers and reputations are directly at stake – impose contractual obligations on their highly paid bankers to bear personal liability for some portion of their banks’ losses from excessive risk-taking or violations of law. This system of “covenant banking” would, in effect, force individual bankers to internalize the costs of their socially irresponsible actions and, consequently, to adopt a more conservative ex ante attitude toward financial and legal risk. It is this last factor that the book’s authors find especially important. Indeed, that’s why they insist on not having bankers’ personal liability depend on individual fault.  To illustrate the basic idea, Hill & Painter discuss how such personal liability agreements might work if a bank is insolvent, bailed out by the government, is assessed a fine or found liable for fraud, or enters into a settlement in lieu of such a fine or judgment.  The discussion is thoughtful, engaging, and gives much food for thought to anyone interested in financial regulation.

Of course, as with any creative proposal, Hill & Painter’s concept of covenant banking is bound to raise many questions and objections, some of which the authors correctly anticipate and discuss in the last part of the book. In my view, the more fundamental potential criticism of their book is that their proposed solution seems too narrow, especially in relation to their broadly painted and multi-factored diagnosis of the ethical degradation of the investment banking industry. The story of this gradual loss of Wall Street’s professional ethos, so forcefully presented in the beginning of the book, is at least as much a structural story as it is an attitudinal one. Yet, the contractual personal liability solution has little to say about the broader structural trends in the financial industry. It is possible that expanding the scope of the proposed solutions would have diffused the focus of the book and diluted the force of its core argument. So, the bottom line is simple: this is a great book, and I hope you will read it with interest.

More importantly, I hope that Wall Street CEOs read this book – and soon!



Cite as: Saule T. Omarova, Contracting for Ethical Banking, JOTWELL (January 4, 2016) (reviewing Claire A. Hill & Richard W. Painter, Better Bankers, Better Banks (The University of Chicago Press, 2015)), http://corp.jotwell.com/contracting-for-ethical-banking/.

Appraisal Arbitrage

Minor Myers & Charles R. Korsmo, Appraisal Arbitrage and the Future of Public Company M&A, Wash. U. L. Rev. (forthcoming 2015), available at SSRN.

Developments in corporate law center on two topics these days—shareholder voting and merger litigation.  One of the more surprising of the many twists and turns in the latter area is the appearance of appraisal arbitrage. The arbitrage characterization applies because the petitioner under section 262 of the Delaware corporate code takes advantage of the section’s standing rule to buy the transferor’s stock after the record date for the vote on the merger, based on a financial analysis that signals a good chance to prove a valuation in excess of the merger price. A number of special-purpose hedge funds have cropped up as players—Merion Capital, now a frequent appraisal plaintiff, raised $1 billion for a fund dedicated to appraisal claims in 2013. The volume of petitions has spiked up.

Volume has increased substantially despite the fact that appraisal is supposed to be brutally unfriendly to plaintiffs, partly because class actions are prohibited and partly because the plaintiff bears the burden to prove every dollar of damages through a ground up valuation of the company. The surge casts a negative light on the permissive the standing rule, which, in contrast to the blocks erected in representative litigation, facilitates buy-ins. The surge in filings also bids reconsideration of the open-ended approach to valuation techniques followed in the Delaware courts. Finally, it calls into question the fed funds plus 5% interest rate applied to appraisal recoveries under section 262. It is alleged that at a time when interest rates have fallen to little more than zero, a petitioner with a substantial stake can turn a profit on a return of the merger price alone, given an assured 5% yield during the litigation period. Critics are pressuring Delaware to amend the statute to turn back the plaintiffs.

In Appraisal Arbitrage and the Future of Public Company M&A, Myers and Korsmo turn back the critics.

This is a model law review article. It succinctly lays out the framework, and then reports on what has been going on lately, reporting an empirical study of Delaware appraisal litigation over the past ten years. The authors produce a series of crisp, telling descriptive statistics. (There is also a regression but it does not really add anything.) They persuade the reader that the appraisal surge, while certainly dependent on the loose standing rule as a door-opener, is not a function of hold up tactics and does not depend on the 5% interest add-on. The petitioners are selective and target low-premium mergers. Appraisal rights thus are being deployed in accordance with their purpose. Indeed, the authors suggest that Delaware expand section 262 to make appraisal available whatever the form of merger consideration.

This is one of those rare cases where there arises a strong inference that an article influenced the development of the law. Everyone in Delaware with whom I have raised the appraisal arbitrage question makes reference to Myers and Korsmo. The Council of the Corporation Law Section of the Delaware Bar Association cited the article when it took the matter up earlier this year. Significantly, the Council left the standing door open and proposed only a tweak of the statute, suggesting (1) a de minimis dismissal opening for petitions including 1% or less of the shares outstanding or involving a merger consideration of $1 million or less, and (2) an interest cutoff option in the company keyed to a payment of all or part of the merger consideration. As it happened, the legislature left the Committee’s suggestions on the table.

Delaware’s adjustment for appraisal arbitrage instead shows up in the caselaw. Vice-Chancellor Sam Glasscock recently has been using the merger price to trump the petitioner’s showing, reasoning that a well-conducted sale process lends confidence in the dollar result. See, e.g., Huff Fund Investment Partnership v. CKx, Inc., 2013 WL 5878807 (Del. Ch.), affirmed 2015 WL 631586 (Del.).  Process concerns have been known to spill over into appraisal cases before, but never to this extent. Even so, the process move makes sense in the present context. Myers and Korsmo pick up on it, mooting a section 262 safe harbor constructed on Revlon principles. This is an intriguing suggestion, but then safe harbors are not the style in Delaware corporate jurisprudence.

Cite as: Bill Bratton, Appraisal Arbitrage, JOTWELL (November 25, 2015) (reviewing Minor Myers & Charles R. Korsmo, Appraisal Arbitrage and the Future of Public Company M&A, Wash. U. L. Rev. (forthcoming 2015), available at SSRN), http://corp.jotwell.com/appraisal-arbitrage/.

Debt, Detroit, Democracy

Melissa B. Jacoby, Federalism Form and Function in the Detroit Bankruptcy, 33 Yale J. on Reg. (forthcoming 2016).

I feel only a bit sheepish for snatching Melissa Jacoby‘s Federalism Form and Function in the Detroit Bankruptcy (Yale J. on Reg. forthcoming) from all the other sections that could claim it, notably Constitutional Law and Courts Law. Although it is the richest law review article I have read in a while—sweeter for being the first in a cycle—I worry that it might fall through the interdisciplinary cracks. Debt rarely takes center stage in constitutional theater these days, ditto bankruptcy procedure in procedure. Even by bankruptcy standards, the project might seem exotic—a deep dive into audio recordings and other primary sources from Chapter 9 (municipal) bankruptcy hearings. Whatever your discipline, you would be mad to miss it. The subject is the biggest-ever public debt restructuring under a statutory scheme. The article is packed with doctrinal, theoretical, and methodological insights. The treatment is sophisticated and empathetic. The policy salience is obvious, as Detroit taps the markets, Chicago totters, Puerto Rico defaults, and the United Nations and the Pope endorse bankruptcy for states.

Chapter 9 of the U.S. Bankruptcy Code is one of the few statutory regimes in the world for public debt restructuring. Its effort to balance federalism and democratic deference against the need to put an over-indebted (likely mismanaged) political unit on a sound financial footing has inspired imitation and criticism. Chapter 9 combines a high barrier to filing with extraordinary deference to the debtor’s policy decisions once it files. There is no bankruptcy estate, no equity, and no liquidation. In theory, states retain sovereignty over municipalities, while federal bankruptcy courts must keep their noses out of municipal affairs. Some commentators have argued that such reticence fuels debtor moral hazard; others have used it to highlight the limitations of Chapter 9 as a framework for bigger, more complex political units.

Until recently, the debate was mostly academic because real political units never restructured under Chapter 9; most of the filing activity involved special tax districts and the like. Detroit’s bankruptcy, coming on the heels of Vallejo and Stockton, CA, Central Falls, RI, and Jefferson County, AL, among others, is arguably a game changer. Having shed over $7 billion of debt in 17 months, Detroit comes closest to testing the proposition that statutory bankruptcy could deliver durable debt relief without compromising people power.

Federalism Form and Function gets at the heart of the question in a novel way. Taking a cue from complex litigation, Jacoby sifts through months of courtroom recordings in real time to draw a framework for managerial intervention by the bankruptcy judge. Those who know the procedure scholarship would not be surprised to discover that courts can exercise tremendous power over the debtor municipality and its creditors through seemingly mundane channels, such as fixing the calendar, appointing mediators and experts, monitoring costs, and conditioning motion rulings. Yet this insight upends the bankruptcy consensus about how Chapter 9 actually works, and poses uncomfortable questions for those who would extend the model to states and countries on the assumption that statutory bankruptcy and third-party adjudication are easily compatible with debtor democracy.

Judge Steven Rhodes used process leverage to force a stream of information out of city officials, then used the information to force the officials to reckon with tort claims, pensions, water services, and other big challenges in a systematic fashion. The all-star team of outsiders assembled under the judge’s direction did exactly what outsiders are meant to do. Unburdened by local political and financial ties, often out of public view, they made practically irreversible decisions with an eye to long-term viability. The outsiders seemed to be people of good will and reasonable priorities: restoring city services, preserving irreplaceable cultural assets, protecting the vulnerable. The end was impressive—a record-fast restructuring, oodles of new money for the city, a renewed sense of possibility—but was it impressive enough to justify the means?

The author comes across as unsettled about the implications of judicial power she documents in Detroit. I was unsettled by my own reaction—I came away from the article in awe of the “Detroit Blueprint.” Intense collaboration among circuit, district and bankruptcy judges, state and local officials left little room for deviation in Detroit. It is as if every part of the process were meticulously rigged to permit a particular range of expressions and outcomes. Thinking outside the box is encouraged; wandering into the woods is unthinkable. No Syriza-Schauble clash-of-democracies circus here. Detroit stayed on the path; now the future looks bright and the all-star team moves on.

Where I live, it is not hard to imagine a city becoming a political football for outsiders whose good will and good judgment are suspect. For all the problems one might have with the Detroit outcome, the Detroit Blueprint could be used in much scarier ways. Federalism Form and Function and its sequels are well-placed to illuminate the possibilities and design the safeguards. No time to waste.

Cite as: Anna Gelpern, Debt, Detroit, Democracy, JOTWELL (October 28, 2015) (reviewing Melissa B. Jacoby, Federalism Form and Function in the Detroit Bankruptcy, 33 Yale J. on Reg. (forthcoming 2016)), http://corp.jotwell.com/debt-detroit-democracy/.

Clayton Christensen comes to Wall Street

Chris Brummer, Disruptive Innovation and Securities Regulation, 84 Fordham L. Rev. -- (forthcoming, 2015), available at SSRN.

In the early 2000s, I spent some time as a fly on the wall of the floor of the New York Stock Exchange. I talked to specialists—those whose job it was to personally manage trading and make a market for particular high volume stocks—including one who had just earned a coveted specialist’s “seat” (price: $3 million). Once upon a time, a seat was practically a license to make money. As market-makers, specialists bought low and sold high on their own accounts. The NYSE specialists I spoke to talked about decimalization, new at the time—the fact that securities were now quoted in pennies instead of in eighths or sixteenths of a dollar. They agreed that it had cut into their profitability. They were already using an electronic system to pair off small customer orders, and they agreed that it actually handled more order volume than they did. None of them seemed to have given much thought to electronic trading, alternative trading platforms, or the derivatives market. Certainly none of them seemed to think these were existential issues that would undermine their 130-year-old business model.

Securities markets are utterly transformed today. Specialists, as they were then, are gone. Electronic trading networks reign, as does algorithmic trading. The NYSE handles less than 20% of US stock trades (it was 80% just a decade ago). Chris Brummer’s new article, Disruptive Innovation and Securities Regulation, is a gorgeous account of how this happened, how law intersected with innovation, and what the implications might be.

We know already that derivatives and financial engineering have profoundly challenged the assumptions underlying corporate law: think of Bernie Black and Henry Hu’s work on empty voting,1 Ron Gilson’s and Chuck Whitehead’s work on risk-slicing beyond the corporate share,2 or Tamar Frankel’s ruminations on how profoundly new technology affects Adolf Berle’s classic analysis of the separation between ownership and control.3 Bill Bratton and Adam Levitin have pointed out how innovations like the synthetic CDO involving a special purpose entity have redrawn the conceptual boundaries of a firm, and done through contract what formerly would have been done through equity ownership.4 For a broader audience, Michael Lewis’s influential book Flash Boys gave many a sense of the complex ecosystem in which high frequency traders operate (along with a sense of outrage about the disadvantage at which retail investors and even their pension and mutual funds are put in those ecosystems).

Chris Brummer’s important contribution here is at least four-fold: first, he illuminates the historical dance, from the New Deal era onward, between securities regulation and financial sector innovation. The history he provides is engaging and precise, and he consolidates in one place information about how particular regulatory moves, like the SEC’s Rule 144A (in 1994) or Regulation NMS (in 2007), unexpectedly rearranged markets and altered the business models of the very intermediaries—exchanges, broker-dealers and the like—they were intending to regulate. Among other unexpected relationships, he points out how greater clarity around the standards for private placements produced greater innovation around private placements. The relationship between clarity or standardization, and innovation, is an important one that does not always make it into conversations about finance or the financial crisis.

Second, Brummer identifies the ways in which new technology (particularly automated financial services and private capital markets, including dark pools and crowd-funding) has disrupted regulatory practice. For example, the SEC promulgated Regulation NMS in order to deal with the market fragmentation problem that electronic trading networks had created. It promulgated Rule 144A to help investors gain access to young, innovative, capital-intensive firms. The combined result, though, was to spur high frequency trading and to move trading off public markets, to the detriment of price discovery and fair treatment for retail investors (not to mention the specialists I once spoke to).

The other thing that comes out is how vast and tricky remains the challenge of consumer protection in this space. Consumer protection regulators like the SEC, and the law-based nature of their expertise, did not come out well during the financial crisis. In the wake of the crisis, policy-making momentum and credibility has shifted toward prudential regulation, and more technical financial expertise. Among the contributions in Brummer’s article is a reminder that someone needs to be thinking hard about consumer protection, and priorities such as creating an equal playing field for “real economy” and retail players, in the midst of all this disruptive innovation.

Brummer’s most significant contribution, though, is to pursue a conversation about how we might respond to the challenges that innovation presents for regulation. Back in 2009, Mitu Gulati and Bob Scott asked why law firms don’t have R&D departments.5 This is a good question (and they provide a fascinating answer) but the question goes beyond just firms. The reality is that law is not terribly good at tracking, let alone engaging in, innovation. This is true even for securities regulation, the area of law perhaps most directly concerned with allocating capital to its best (which often means its most innovative) uses. Brummer’s article has done us a real service by setting out a thorough, insightful description of how far reality has strayed from the static, institution-oriented market structure that New Deal-era regulation assumes. His helpful proposals are to expand the regulatory perimeter, to consider the benefits and limits of objectives-based regulation, and to consider “adaptive financial regulation.” We could perhaps even go further, to consider the ways in which financial regulation needs to be reframed to allow us to think about innovation as a first order regulatory challenge. How might our perspective change, if we started from the point to which Brummer brings us: from a sense of the historical dance between regulation and innovation, and a recognition of the ways in which regulation itself must anticipate and respond to the disruptive and undermining effects of private sector innovation?

  1. Henry Hu and Bernie Black, Empty Voting and Hidden (Morphable) OwnershipBusiness Lawyer, 2006 at 1011. []
  2. Ronald J. Gilson and Charles K. Whitehead, Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets, 108 Colum. L. Rev. 231 (2008). []
  3. Tamar Frankel, The New Financial Assets: Separating Ownership from Control, 33 Seattle U. L. Rev. 931 (2010). []
  4. William W. Bratton and Adam J. Levitin, A Transactional Genealogy of Scandal: From Michael Milken to Enron to Goldman Sachs, 86 S. Cal. L. Rev. 783 (2013). []
  5. Mit Gulati and Robert E Scott, The Three and a Half Minute Transaction: Boilerplate and the Limits of Contract Design, 40 Hofstra L. Rev. 1 (2012). []
Cite as: Cristie Ford, Clayton Christensen comes to Wall Street, JOTWELL (September 21, 2015) (reviewing Chris Brummer, Disruptive Innovation and Securities Regulation, 84 Fordham L. Rev. -- (forthcoming, 2015), available at SSRN), http://corp.jotwell.com/clayton-christensen-comes-to-wall-street/.

Private Ordering in Corporate Litigation

Verity Winship, Shareholder Litigation by Contract, __  B.U. L. Rev. (forthcoming, 2015, available at SSRN.

The debate over litigation bylaws has been percolating in Delaware for several years, but it shifted into high gear last year, when the Delaware Supreme Court held unexpectedly that a fee-shifting bylaw was “facially valid.” ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 558 (Del. 2014). This decision prompted discussion of a corporate litigation crisis, which seems to have abated with action this summer by the Delaware General Assembly, passing legislation prohibiting fee-shifting bylaws and charter provisions for Delaware stock corporations. This legislation also addresses forum selection clauses, authorizing bylaws, or charter provisions designating Delaware as the exclusive forum for claims relating to “internal affairs” and prohibiting provisions designating courts outside of Delaware as the exclusive forum for such claims. Although the immediate threat of crisis has been abated, important issues remain regarding bylaw- and charter-provision-regulating corporate litigation. In Shareholder Litigation by Contract Verity Winship offers a useful framework for thinking about these issues.

Winship begins with a sensible premise: “procedural law should not be used to waive mandatory provisions of substantive law.” (P. 6.) Of course, she recognizes that the number of mandatory provisions in state corporate law is few, but she includes among those provisions “the core duty of loyalty claim within the umbrella of state-law fiduciary suits.” (P. 45.) This is a controversial claim, but one that seems to be shared by the Delaware General Assembly, as the implicit motivation for prohibiting fee-shifting is the desire to preserve fiduciary duty litigation.

It is probably worth noting that the legislation prohibiting fee-shifting was not drafted by members of the Delaware General Assembly, but rather by the Council of the Corporation Law Section of the Delaware State Bar Association, an organization comprising top Delaware corporate lawyers, who have a strong pecuniary interest in a vibrant litigation environment. That said, anyone who believes that fiduciary duty litigation is an important part of the corporate governance system should also endorse Winship’s aspiration to “prevent procedural provisions from being used to kill shareholder litigation altogether” and to “also avoid throwing the baby out with the bathwater.” (P. 6.)

Winship’s approach depends on a contracting framework, which also is not uncontroversial, even though the ATP used this framework in approving the fee-shifting bylaw in that case. The Court in that case reasoned:

Delaware follows the American Rule, under which parties to litigation generally must pay their own attorneys’ fees and costs. But it is settled that contracting parties may agree to modify the American Rule and obligate the losing party to pay the prevailing party’s fees. Because corporate bylaws are “contracts among a corporation’s shareholders,” a fee-shifting provision contained in a nonstock corporation’s validly-enacted bylaw would fall within the contractual exception to the American Rule. Therefore, a fee-shifting bylaw would not be prohibited under Delaware common law. (Pp. 9-10.)

In Private Ordering with Shareholder Bylaws, my co-authors and I suggested that shareholders in public corporations perform not only the conventional functions of selling, voting, and suing, but they also engage in contracting through bylaw amendments. One limitation on our proposal is embedded in the term “shareholder bylaws.” The fee-shifting bylaw in ATP was a “director bylaw,” which seems unlike “contracts among a corporation’s shareholders.” We criticized the Delaware Supreme Court’s opinion in CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227, 238 (Del. 2008) for placing too much bylaw power in the corporate directors, and ATP suffers from this same shortcoming.

Critics of our contracting view note that bylaws are not really contracts, but are simply interpreted by the Delaware courts according to contract interpretation principles. You can see Kurt Heyman, a distinguished Delaware practitioner, making this argument in a recent panel discussion at Fordham Law School. This, of course, is merely a formal objection, which we assume that everyone who endorses the contracting framework recognizes. (Winship dedicates an entire section of her article to examining various caveats to treating bylaws and charters as contracts.) The issue is deciding the extent to which shareholders ought to be allowed to engage in private ordering. Or, in Winship’s words, “Should there be any limit to the procedural provisions to which the parties can contract?” (P. 6.)

Winship’s short answer is “yes.“ Bylaws should be limited by mandatory provisions in the statute, including the newly adopted fee-shifting prohibition. But if the underlying aspiration is to allow individual firms to act as “laboratories of corporate governance,” the number of mandatory provisions must remain rather small. Thus, bylaw provisions altering discovery rules, requiring the posting of a bond, implementing contemporaneous ownership requirements, identifying additional prerequisites to filing derivative lawsuits, and myriad other issues are candidates for private ordering under a robust contracting system.

This article is a full-throated defense of private ordering in corporate governance. It is well written, thoroughly researched, doctrinally sophisticated, and conceptually challenging. And, if it is not clear by now, I add that it is well worth reading.

Cite as: D. Gordon Smith, Private Ordering in Corporate Litigation, JOTWELL (August 10, 2015) (reviewing Verity Winship, Shareholder Litigation by Contract, __  B.U. L. Rev. (forthcoming, 2015, available at SSRN), http://corp.jotwell.com/private-ordering-in-corporate-litigation/.

Whistleblowers as Securities Fraud Detectors

Securities fraud presents one of the more vexing challenges for financial regulators and policymakers. Each new financial crises and catastrophic fraud frequently begets new tools to fight securities fraud. In a thoughtful recent article, Better Bounty Hunting: How the SEC’s New Whistleblower Program Changes the Securities Fraud Class Action Debate, Professor Amanda Rose examines the SEC’s new whistleblower program as a tool for securities fraud detection, and explores its potential impact on the old fraud detecting tool of class action lawsuits.   The motivating argument of the article is that the SEC’s new Whistleblower Bounty Program (WBP) created by Dodd-Frank can serve as a superior alternative to the traditional fraud-on-the-market (FOTM) class action lawsuits as a tool for securities fraud detection and deterrence.

Professor Rose articulates this argument in a logical, measured fashion. She begins by providing background information on the origins of FOTM class actions and the WBP, which is designed to pay large sums to eligible individuals who provide valuable, original information about frauds that result in $1 million or more of penalties. Building on that background, Professor Rose then contends that the WBP could reduce the relative benefits associated with FOTM lawsuits while increasing their relative costs thereby making them a less desirable tool to combat securities fraud. With cautious optimism, she believes that the generous bounty of the WBP and the steep costs often associated class action lawsuits could ultimately lead tipsters who are aware of securities fraud to pursue redress through the whistleblower route rather than the class action route. However, to the extent that the WBP does not function as a feasible replacement for FOTM suits, Professor Rose introduces the innovative idea of adding a qui tam provision in the current whistleblower program as a modest improvement over FOTM suits.

The success and impact of the WBP remains to be seen as the program is still in its infancy. According to the SEC’s 2014 WBP report to Congress, a total of only fourteen awards have been granted since the creation of the program.   That said, the SEC has received thousands of tips annually since its inception, and those tips have been increasing year to year. The long term, sustainable success of the program will depend largely on the willingness of individuals with high-quality information about securities fraud to use the program, and the program’s vigilant administration by the SEC. While a more definitive verdict on the WBP remains forthcoming, Professor Rose has provided a promising, underappreciated preview of the program’s full potential.

Ultimately, perfect fraud detection and deterrence in the securities marketplace is a noble but elusive goal. Securities fraud is a persistent, diverse problem that requires a diverse toolkit to solve in a better way. Traditional tools like class action lawsuits are not always the best tools for tackling the diverse variations of securities fraud in the marketplace. In the end, traditional tools like class action lawsuits will have to be complemented, refined, and possibly supplanted by new and better tools such as smart whistleblower-based solutions, as Professor Rose has skillfully articulated in her article, in order to better detect and deter securities fraud in the marketplace.

Cite as: Tom C.W. Lin, Whistleblowers as Securities Fraud Detectors, JOTWELL (July 7, 2015) (reviewing Amanda Rose, Better Bounty Hunting: How the SEC's New Whistleblower Program Changes the Securities Fraud Class Action Debate, 108 Nw. U. L. Rev. 1235 (2014)), http://corp.jotwell.com/whistleblowers-as-securities-fraud-detectors/.

Rethinking Insider Trading Regulation

  • Yesha Yadav, Insider Trading in Derivatives Markets, 103 Georgetown L.J. 381 (2015)
  • Yesha Yadav, Structural Insider Trading, Vanderbilt Law and Economics Research Paper No. 15-8 (March 27, 2015), available at SSRN.

The question of distinguishing between the informational advantages insiders and outsiders may and may not legitimately exploit in trading in the financial markets is perennial: is securities regulation about achieving a level playing field for investors or about imposing sanctions for certain fiduciary and fiduciary-like breaches of duty which go beyond traditional remedies for such breaches. The Second Circuit’s decision in US v Newman emphasizes the fiduciary duty component of liability: at least in a criminal case involving tipping by insiders “the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.”

In these papers Yesha Yadav focuses on two specific problem areas in insider trading regulation, relating to trading in credit default swaps (CDS) by lenders and “structural” trading using a combination of preferential access to information and locational advantages. Both examples present arguments for a rethinking of how insider trading regulation should address the realities of modern, complex, financial markets.

The contexts of the two papers differ. With respect to Insider Trading in Derivatives Markets, Professor Yadav is addressing a context in which regulators have decided to extend insider trading prohibitions to derivative markets. In Structural Insider Trading, on the other hand, Professor Yadav identifies “cracks in regulation” (p. 4).

Congress extended the prohibition of insider trading to transactions in swaps and futures in the Dodd-Frank Act in 2010 and the CFTC implemented the prohibition in rules issued in 2011. By 2010 concerns about the risk of insider trading in credit derivatives was not exclusively a US domestic concern: the Joint Forum of transnational standard setters for financial regulation had identified this as an issue in 2008. But Professor Yadav persuasively argues that trading on insider information in CDSs may improve the informational efficiency of the securities markets, benefiting shareholders. Lenders with access to inside information about their borrowers have incentives to transfer the credit risk associated with their lending, and their ability to hedge risk encourages lending, which benefits shareholders “at least in the near term.”(p. 416) The story is not all positive, however, as lender activity with respect to CDSs may harm shareholders, and shareholders have limited capacity to monitor lenders (p. 417). Lenders may transact in ways that over-emphasize bad news (p. 419).

Professor Yadav suggests that lenders and borrowers might be able to contract around insider trading liability to fix the doctrinal problem. However, she notes that this fix might not work because corporate debtors suffer from a weak bargaining position and monitoring a lender’s compliance with the terms of a contract would be challenging. As usual in the insider trading context disclosure could play a role, although a borrower would have limited options to respond to a lender’s disclosed proposed CDS trades (p. 428). Insider CDS trading raises more general questions about the fit between established doctrine and the realities of the markets: the “tension between law and reality…dismantles long-held assumptions in theory.”

Structural Insider Trading similarly focuses on realities of the financial markets to challenge established assumptions about insider trading law. High speed algorithmic trading strategies combined with geographic proximity to trading venues provides an informational edge (p5) (of course, this development, together with the complex harmonization-differentiation picture of financial regulation also challenges some of the thinking about the decreasing relevance of geography to finance). The informational edge creates a tension between “speed in trading and the policy goal of ensuring broad and equal access to information.”(p 5) Professor Yadav argues:

structural insider trading inverts the traditional policy priority underpinning the prohibition against insider trading. Under Rule 10b-5, liability is justified as a way to protect insiders despite negative effects on market efficiency. By contrast, structural insider trading privileges market efficiency over investor protection, in giving structural insiders the ability to trade on soon-to-be public information despite costs to investors-at-large.

These are two papers which demonstrate very clearly and usefully a need to rethink one area of financial regulation for a complex, evolving, market reality.

Cite as: Caroline Bradley, Rethinking Insider Trading Regulation, JOTWELL (May 11, 2015) (reviewing Yesha Yadav, Insider Trading in Derivatives Markets, 103 Georgetown L.J. 381 (2015) and Yesha Yadav, Structural Insider Trading, Vanderbilt Law and Economics Research Paper No. 15-8 (March 27, 2015)), http://corp.jotwell.com/rethinking-insider-trading-regulation/.