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.


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?


Law Matters (A Bit)

• Brian R.Cheffins, Steven A. Bank, & Harwell Wells, Law and History by the Numbers: Use, But with Care, UCLA School of Law, Law-Econ Research Paper 13-21 (2014), available at SSRN.
• Brian R. Cheffins, Steven A. Bank, & Harwell Wells, Questioning "Law and Finance:" US Stock Market Development, 1930-1970, 55 Bus. Hist. 598 (2013), available at SSRN.

The relationship between civil and economic governing institutions and economic development is significant. Law matters to economic development. Acemoglu’s and Robinson’s comprehensive overview in Why Nations Fail: The Origins of Power, Prosperity, and Poverty provides a compelling case for the proposition that extractive institutions, in either sphere of civil life, can significantly retard economic progress and result in poor living conditions for the majority of people in a given society. Largely the province of development economists studying political institutions, the inquiry into the relationship between governance and economics in the corporate sphere was catalyzed by the famous work of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (LLSV) in the late 1990s.  The relationship among economic development and the institutions of finance – corporations, markets, and financial institutions – has since progressed from development economics to corporate legal scholarship.

The study of economic development is, necessarily, historical, and is in its nature largely comparative.  A welcome corollary in legal scholarship to the introduction of development economics is a renewed interest in corporate and financial history.  Cheffins, Bank, and Wells (CBW), all excellent contributors to this industry, have performed a notable service with a recent interesting pair of papers.  In Questioning Law and Finance, they turn from the traditional comparative approach of the development literature to examine, longitudinally, what that literature might teach us about economic development in 20th century America as a function of corporate and securities law.  In Law and History by the Numbers, they step back to examine the extent to which empirical research of the type used in the economics literature can shed light on corporate legal analysis.

Financial development in the United States presents, on the surface, something of a paradox.  On the one hand, it has been accepted wisdom that American corporate law (and especially that of Delaware, on which CBW focus), traditionally has been management-friendly and relatively lax with respect to the interests of shareholders.  On the other hand, there is no nation on earth in which equities markets are as broad and deep as in the United States.  One might think that corporate laws that shielded managerial expropriation from shareholders would retard market development.  One would, evidently, be wrong.

CBW examine three proxies for the shareholder-protective nature of Delaware corporate law – LLSV’s anti-director rights index (ADRI), Djankov, La Porta, Lopez-de-Silanes, and Shleifer’s (DLLS) recoding of the ADRI to diminish the positive scoring of enabling statutes, and Spamann’s recoding of the ADRI to account for law in practice.  The refinements from LLSV’s original version to Spamann’s version produce a progressive downgrading of US law.1  In both DLSV’s and Spamann’s versions, US law fares rather poorly when compared with common law regimes, and still poorly, although rather less so, when compared with civil law regimes.  A simplistic reading of these results would imply that the US stock market would be weaker than the average.  But the opposite is true.

The challenge, as CBW see it, is to the “law matters” thesis in the corporate governance segment of the development literature.  If U.S. markets flourished despite poor investor protections, maybe law doesn’t really matter so much at all.  CBW ask whether the work attributed to corporate governance law could, perhaps, be attributed instead to rigorous securities regulation, which began to arise in the United States in the 1930s.  But this won’t do, either, because tracking securities regulation against market development presents another paradox:  The regulated market was desultory during most of the period examined, while the unregulated over-the-counter market flourished.

So the U.S. presents a challenge to the “law matters” thesis, at least with respect to the development of equity markets.  CBW argue that factors other than law, or at least corporate and securities law, are more explanatory than law of this development.  They note a diminution of the collective memory of the 1929 Crash as the market approached revival in the 1950s, the change in trust laws permitting pension funds to invest in equities, and other laws such as the 1954 tax dividend credit provide some of the answers.

CBW are certainly right, that extra-legal factors such as the ones they identify were important drivers in the development of the U.S. equities markets.  The 1950s change in New York trust law was critically important, but also came at time during which the New York Stock Exchange had embarked on an intensive public relations campaign to increase trading volume.  (The NYSE actually commissioned the 1952 Brookings Study to which they refer.)  Significant changes in financial structure also likely mattered, as the Delaware courts in the 1930s (among others) liberalized case law to permit the defeat of preferred stock preferences, thus diminishing the attractiveness of a form of investment quite popular in the first third of the century.  Mid-century also saw the disinvestment of many of the founding families of America’s largest corporations who had, for some time, held controlling interests.  The financial and business landscape was complex.2

CBW’s important work directs us to be careful in the power we attribute to law.  But just as they caution against over-reliance on empiricism, it is also important, as they demonstrate, to be attentive to the normative environment.  Their work ends in the 1970s.  But that decade introduced a series of reforms that have led in the U.S. to the development of a strong ethic of shareholder-centrism that previously was absent from American managerialism.  While not exactly law, this ethic is a natural corollary of changes in the composition of corporate boards (or so I have argued) and, to some extent, changes in corporate law itself.  The development consequences are potentially striking. In their recent paper, The Origins of Stock Market Fluctuations, Daniel Greenwald, Martin Lettau, and Sydney C. Ludvigson, have attributed substantial portions of real stock market wealth since 1980 to shareholder expropriation from workers.3

Putting this trend in light of the governance-development literature tells a frightening story.  One can infer that the institutions of corporate governance that are praised as increasingly democratic are in fact, on a massive scale, an example of precisely the kind of extractive framework that Acemoglu and Robinson argue impoverishes nations.  While the distorting effect the stock market has on wealth distribution was observed as early as the early 1970s, the extraordinary imbalances in wealth distribution that have recently provided political fodder may be attributed to precisely the kinds of factors that interest CBW.  Their contribution is welcome, and one hopes to see it stimulate considerably more attention by corporate legal scholars to questions of law and economic development.

  1. LLSV, DLSV, and Spamann all focus on Delaware law as a proxy for US law as well. []
  2. Lawrence E. Mitchell, Financialism<: A (Very) Brief History, 43 Creighton L. Rev. 323 (2007); Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry (2007). []
  3. Daniel L. Greenwald, Martin Lettau & Sydney C. Ludvigson, The Origins of Stock Market Fluctuations, NBER Working Paper No. 19818 (January 2014). []

Demystifying the Fed

Peter Conti-Brown, The Institutions of Federal Reserve Independence, Rock Center for Corp. Governance at Stanford Univ. Working Paper No. 139 (2014), available at SSRN.

Exactly one hundred years after its birth, the Federal Reserve remains one of the most powerful and mysterious institutions in the world. The recent global financial crisis made it exceedingly clear how much the Fed can do – and, in fact, does do – to shore up failing financial markets and prevent the entire economic system from collapsing. That same display of strength under fire, however, exposed the darker side of Fed power: what if it’s abused or misused in ways that can hurt all of us? Both revered and feared for its apparent ability to pull at the hidden strings that keep the national (and even global) economy going, the Fed has emerged from the latest crisis with an expanded regulatory mandate and an even greater political visibility. Some applaud this development, while others criticize it. Yet, despite all of our post-crisis wisdom and divided opinions, how well do we know the Fed? Do we actually understand the sources and nature of the Fed’s century-old “magic”?

If you hesitate at all before giving an affirmative answer, you should read Peter Conti-Brown’s recent article, The Institutions of Federal Reserve Independence, a brand new draft of which is currently available on SSRN. This piece is an opening move in Conti-Brown’s larger project – a book entitled The Structure of Federal Reserve Independence (Princeton University Press, forthcoming 2015). The book promises to offer a comprehensive and historically-grounded analysis of the Fed’s “independence,” that critical ingredient of its powerful magic. To Conti-Brown, however, the Fed’s independence is much more than a dry legal concept – it is a complex real-life phenomenon, a unique “ecosystem” continuously evolving through interactions among multiple legal, political, administrative, ideological, and even cultural factors. From his perspective, it doesn’t make sense to speak of the central bank’s “independence” as a static formal attribute that means the same thing in every context. Instead, the task is to understand the key mechanisms, both formal and informal, through which the Fed exercises its independence vis-à-vis specific parties, or audiences.

While we have to wait for a full account of the logic and operation of that ecosystem in Conti-Brown’s forthcoming book, his first contribution to this fascinating project gives us a proper taste of what’s coming. In this article, Conti-Brown challenges the prevailing notion of the Fed’s independence as predominantly, if not entirely, a creature of law. He criticizes the administrative law scholars’ myopic focus on the President’s removal power as the sole determinant of an agency’s “independent” status, as well as economists’ and political scientists’ assumption that law is the ultimate source of the central bank’s independence. Conti-Brown’s reaction to this assumption is startlingly decisive: “The idea that Fed independence is determined by law is wrong.” Through painstaking examination of every feature that arguably makes the Fed more or less accountable to, or autonomous from, outside audiences, public and private, the article seeks to demonstrate “the law’s subtlety and, sometimes, its irrelevance.” 

For example, Conti-Brown argues that, contrary to common misconceptions, the Fed’s unique budgetary independence is not a direct result of any express statutory authorization but an extraordinary product of decades of interaction between the law and various extra-legal institutions, such as economic doctrines and the Fed’s own open market operations. He also show that the oft-cited statutory requirement of non-renewable fourteen-year terms for Fed Governors, in practice, does not prevent the President from “stacking” the Fed with his/her appointees.  These are just two examples of Conti-Brown’s efforts to defy simplistic explanations and to expose the complex reality of the “law on the books” interacting with the “law on the ground.” The article goes in great detail through the legal and non-legal mechanisms of the Fed’s independence vis-à-vis three sets of actors: Congress, the President, and the private banks that are members of the Federal Reserve System.

By contextualizing the Fed’s “independence” in this manner, Conti-Brown seeks to enrich our collective understanding of the Fed’s operation and role. Such knowledge is inherently empowering: it broadens our intellectual horizons and potentially unlocks new avenues for creative regulatory design and policy-making. Of course, an intense investigation of this kind tends to be heavy on technical detail that does not necessarily make for an easy read.  Not surprisingly, this article is dense and will keep your mind actively engaged all the way to the end. But the result will be well worth the effort. And, if you are anything like me, reading this provocative article will make you wait impatiently for Conti-Brown’s book that (hopefully) will tell a much fuller story of the Fed and its unique independence.


Managing Global Supply Chains: Coca Cola and Sugar in Brazil

Salo V. Coslovsky & Richard M. Locke, Parallel Paths to Enforcement: Private Compliance, Public Regulation, and Labor Standards in the Brazilian Sugar Sector, 41 Pol & Soc 496 (2013), available at SSRN.

An article in the Wall Street Journal in June 2013 described supply chain management as “The Hot New M.B.A.” The Whitman School of Management at Syracuse University says it has been focusing on supply chain issues since 1919, and says that now “[s]upply chain managers very often hold the key to corporate profitability.” But as well as managing supply chains from the perspective of efficiency, corporations also need to manage their legal and reputation risks, especially when their supply chains are global. Transnational corporations manage these risks by developing and monitoring compliance with their own codes of conduct. At the same time the states where producers and manufacturers operate have, and are developing, their own regulatory regimes.

In a special issue of Politics & Society on regulation in Latin America, Salo Coslovsky and Richard Locke examine interactions between private codes and public regulation focusing on Coca-Cola’s management of working conditions in its sugar supply chain in Brazil. As the authors point out, working conditions in the sugar production industry have generally not been good: sugar production inherently involves hard work in hot climates, and large and politically connected family firms are involved in sugar production in Brazil. Recent events illustrate that focusing on working conditions does not tell the whole story: in October 2013 Oxfam published a report which argued that increasing demand for sugar was encouraging large companies to displace poor sugar farmers. Coca-Cola promptly promised to take action to protect land rights of farmers in sugar-producing areas. Nevertheless, Coslovsky and Locke describe an interaction between private and public regulatory regimes that improves working conditions for sugar producers. And it is the interaction that matters: public regulation and Coca-Cola’s efforts combine to help workers.

The article is based on quantitative and field research: the authors had access to 116 audits commissioned by Coca-Cola carried out between 2002 and 2008, and they carried out “field visits to a stratified sample of nine mills and farms in São Paulo and Pernambuco and interviews with 80 representatives of private, public, and nonprofit entities relevant to the sugar sector in Brazil.’ The interviewees comprised 45 informants at farms and mills, 29 representatives from labor unions, community groups, and government agencies, and Coca-Cola officials. Interviews were carried out in Portuguese without translators, as the authors are fluent in Portuguese. The authors are conscious that data about improvement in performance on the audits might be the result of gaming the system, but they find independent evidence of improvement in working conditions.

The private sector auditors in the story specialize in labor standards, rather than in the sugar production industry. But the authors found that the auditors could act as intermediaries, communicating the need for change from managers who understood that certain changes could reduce accidents or improve productivity to more senior managers who might otherwise oppose change. The auditors could facilitate firm-level change. At the same time, the actions of public regulators helped to protect workers in general although they might not be able to effect firm-level change. The interaction between these public and private regimes is a rather mysterious sort of interaction. Coslovsky and Locke tell a story in which public and private actors work independently, pursuing their own strategies, and yet the combination of their actions helps workers. They say:

although private and public agents rarely communicate, let alone coordinate with one another they nevertheless reinforce each other’s actions. Public regulators use their legal powers to outlaw extreme forms of outsourcing. Private auditors use the trust they command as company insiders to instigate a process of workplace transformation that facilitates compliance. Together, their parallel actions block the low road and guide targeted firms to a higher road in which improved labor standards are not only possible but even desirable.

The authors recognize that they cannot “disentangle the separate effects of public versus private interventions and apportion separate credit to each” but they argue that their data support the idea that public and private regulation can complement each other to improve labor standards. At the end of the article they raise some important questions about the idea of public and private regulatory interaction. In a world in which public and private regulatory schemes interact constantly, within states and across state borders, this article raises some important questions–and also provides some basis for hope.


Justifying Fiduciary Law

•  Paul B. Miller, A Theory of Fiduciary Duty, 56 McGill L.J. 235 (2011), available at SSRN.
•  Paul B. Miller,Justifying Fiduciary Duties, 58 McGill L.J. 969 (2013), available at SSRN.
•  Paul B. Miller, Justifying Fiduciary Remedies, 63 U. Toronto L.J. (forthcoming 2013), available at SSRN.

Fiduciary law is pervasive. The distinctive duty of loyalty that is the hallmark of fiduciary law arises in myriad private relationships, including guardianships, employment relationships, trusts, business organizations, and professional relationships in law, medicine, and other fields. Recently legal scholars and courts have extended the logic of fiduciary law to public servants and nation states.

Despite its manifest importance, fiduciary law has not achieved the same stature as the other pillars of private law – torts, contracts, property, and unjust enrichment. Fiduciary law has been described as “messy,” “atomistic,” and “elusive,” and one commentator recently observed, “fiduciary law has been characterized as one of the least understood of all legal constructs.” Perhaps as a result of these conceptual challenges, law professors traditionally have taught fiduciary law in small portions, complicating the law student’s search for overarching principles.

Paul Miller is among a small group of legal scholars attempting to advance private law theory by justifying fiduciary law. In a series of recent articles – A Theory of Fiduciary Liability, Justifying Fiduciary Duties, and Justifying Fiduciary Remedies, Miller builds on the increasingly accepted notion that fiduciary relationships are distinctive, but offers a novel account of fiduciary law.

Miller’s account begins with the conception of a fiduciary relationship, which he defines as “one in which one party (the fiduciary) exercises discretionary power over the significant practical interests of another (the beneficiary).” Miller develops this concept in A Theory of Fiduciary Liability, which draws heavily on prior work of other fiduciary law scholars.1

In Justifying Fiduciary Duties, Miller asserts, “the key implication of the definition is that the exercise of power by one person over another is the object of the fiduciary relationship.” (P. 1012.) Miller describes this fiduciary power as a form of authority, which the fiduciary exercises over the affairs of the beneficiary. Although the fiduciary is effectively an extension of the beneficiary, the parties to a fiduciary relationship cannot specify all actions of the fiduciary in advance. Thus, fiduciaries exercise discretion.2

In exercising discretion, the fiduciary is expected to operate within the scope of the fiduciary authority, and any discretionary actions “must be presumptively conducted for the sole advantage of the beneficiary.” (P. 1020.) The justification for the fiduciary duty of loyalty follows naturally: “The conflict rules constitutive of the duty of loyalty constrain fiduciaries in the exercise of fiduciary power…. The duty of loyalty secures the beneficiary’s legitimate expectation that fiduciary power … will be used only to achieve her ends.” (P. 1020-21.)

In Justifying Fiduciary Remedies, Miller adds to his account of fiduciary law by examining remedies for fiduciary breach, which he calls “notoriously potent.” The standard remedy of disgorgement measures damages by reference to the unfaithful fiduciary’s gain, rather than the beneficiary’s loss. As a result, fiduciary remedies are often viewed as inconsistent with notions of corrective justice. In this paper, Miller relies on his earlier justification of the duty of loyalty to challenge the conventional wisdom about disgorgement, arguing that disgorgement is consistent with formal corrective justice because it “vindicate[es] the exclusive claim beneficiaries hold over fiduciary power….” (P. 4.) Stated another way, “No one is entitled to gain from the execution of a fiduciary mandate save the beneficiary; to the extent that there are such gains, they belong to the beneficiary.” (P. 61.)

This brief summary of Paul Miller’s trilogy of articles necessarily bypasses much of the nuance in the papers, but even this quick overview reveals Miller’s account of fiduciary duty as a substantial contribution to the fiduciary canon.

  1. See, e.g., D. Gordon Smith, The Critical Resource Theory of Fiduciary Duty, 55 Vand. L. Rev. 1399, 1402 (2002) (“fiduciary relationships form when one party (the ‘fiduciary’) acts on behalf of another party (the ‘beneficiary’) while exercising discretion with respect to a critical resource belonging to the beneficiary”). []
  2. See D. Gordon Smith & Jordan C. Lee, Discretion, 75 Ohio St. L.J. __ (forthcoming 2014). []

Cyber Finance Considered

Tom C.W. Lin, The New Investor, 60 UCLA L. Rev. 768 (2013).

Tom C.W. Lin’s The New Investor is well worth a read.  It’s about algorithmic trading, high-frequency-trading, flash crashes, and cyber attacks, and how they happen to be, could be, should be, and shouldn’t be changing our thinking about investment and securities regulation.  I picked the paper up from the top of the stack of papers in my office due to feelings of insecurity.  Yes, I had read the financial press with more than usual attention in the wake of the flash crash and had done some homework on dark pools, but I still had the sense I was missing something that others had managed to assimilate.  So I eagerly accepted this paper’s offer of a knowledgeable overview.

I am pleased to report that I was better informed than I had feared.  At the same time, the paper taught me all sorts of stuff  I was glad to learn.  The lesson was a pleasure.  The writing is excellent, the scope broad, the organization intelligent, and the tone measured.  But what about the policy bottom line?  A full and appropriate range of warnings emerges from the paper’s report of technical shortcomings.  There’s also a succinct review of structural regulatory shortcomings.  At the same time,  Professor Lin likes this stuff more than he fears it.  The “new investor” is a function of artificial intelligence, which in turn follows from mathematical inputs. The paper compares the new investor categorically to the rational actor investor of orthodox financial economics and the behaviorally challenged investor of recent academic fashion, and the new investor emerges from the comparison looking pretty good.

I can go along with that.  But I balk when Lin concludes: “The new investor is in many ways Graham’s intelligent investor modernized….” These are fighting words when spoken to a financial conservative like me.  Benjamin Graham and his early twentieth century contemporaries divided the population of stock and bond holders into investors and investments and speculators and speculation.  Investment was always a good thing, while speculation was sometimes a destructive thing.  Modern financial economics long ago cast the distinction into the dustbin, but I keep pulling it back out because it retains explanatory power.  More to the point, I put algorithmic trading and high-frequency trading on the speculative side of the line.  The placement impacts my cost-benefit take, which is less positive than Professor Lin’s.

This is a comment on, not a criticism of, a paper that had the great benefit of prompting some thinking.


Stress Renaissance

Robert F. Weber, A Theory of Stress Testing of Financial Institutions as a Deliberative Exercise, University of Tulsa Legal Studies Research Paper No. 20013-01 (June 2013), available at SSRN.

Reading about the fatal flaws and failures of financial reform day in and day out can make you forget things. Like the actual contents of financial reform…and the fact that it is happening under our noses even as we curse statutory nonsense and the glacial pace of rulemaking. Robert Weber’s article on stress tests is a healthy reminder that financial regulatory methods have changed in important ways since 2008, and that we have a lot of figuring-out to do about them.

Stress tests in finance do three things. First, they help firms identify and manage risk from adverse shocks—a spike in interest rates, a collapse in housing prices, a sharp slowdown in economic growth, or a government debt default. Second, they help regulators judge the resilience of individual firms and financial systems. Third, they help communicate information about risk and resilience to the markets and to the public at large, as well as to narrower constituencies of financial firms and their regulators.

The basic idea of stress testing is not new; I learned that depending on how you count, it goes back at least to Leonardo da Vinci or to the U.S. savings and loan crisis. Financial regulators have used stress tests here and there for over two decades to gauge the riskiness of thrifts’ derivatives plays, the resilience of banks’ trading portfolios, and the stability of entire national financial systems, among others.

In retrospect, the year 2009 may come to look like a turning point, when stress tests began to subsume and eclipse key methods of regulating financial institutions. Consider this: in the old days, national supervisors told banks to keep their capital above the more-or-less arbitrary minimum level agreed in Basel. For U.S. banks, breaching magic-number thresholds brought on “prompt corrective action” (PCA)—at least in theory, restrictions on dividends, acquisitions, asset growth—and at the extreme, resolution. But beginning in 2009, the number that really matters for biggish banks, bank holding companies, and systemically important financial institutions is the capital they have left in a “severely adverse” stress test scenario. The ad-hoc stress tests used in 2009 to decide whether the largest U.S. banks needed capital from TARP have morphed into a statutorily mandated annual cycle of supervisor- and firm-conducted exercises. A parallel process is underway in Europe. While capital adequacy still occupies the core (and the bulk) of institutional regulation, questions of who designs and administers the stress tests, how, and to what end become all-important.

In stark contrast to the old PCA regime and the scattered use of stress tests pre-crisis, today’s regime is designed in important part for public consumption. The tests’ job description has expanded from internal risk management and supervision, to serving as vehicles of market discipline for banks and political accountability for their regulators. The 2009 and 2010 U.S. tests are credited with the return of public confidence in the U.S. financial system, which benefited both banks and their regulators. On the other hand, European stress tests became the source of considerable political embarrassment, with concrete implications for the design of Europe’s banking union.

Robert Weber’s article is a wonderful resource for anyone seeking to develop a view on what stress tests are and what they should do in financial regulation. It has thorough genealogies, un-gimmicky typologies, theory, prescription, and even a bit of poetry between the lines.

I learned about stress tests and adjacent risk management methods, from their origins in engineering (how will the bridge collapse?), to their unlikely emergence as part of U.S. thrift deregulation, and their relationship to Value at Risk methodologies. I was especially glad to get frequent reminders of the transplant quality of stress tests: tools that help manage failure in physical systems may not work the same way for social systems. Throughout, Weber treats complex technical material with freshness and clarity, which makes the article enjoyable and teachable.

It would be unfair to present the project as mere exposition (though you can tell I really loved that part). The author’s overarching purpose is to recast what stress tests should do, and how. He draws the distinction between “stress tests as assurance” and “stress tests as deliberation.” The former is a static, top-down, outward-looking snapshot audit exercise. The latter is dynamic, interactive, and soul-searching—staring failure in the eye and seeing a reflection of your soul. The distinction maps onto the familiar descriptions of old (bad) and new (good) governance. The policy proposal is to get away from the old and double down on the new.

The distinction between stress-tests-as-assurance and stress-tests-as-deliberation is very nicely developed in the paper and useful in practice. It highlights the perils of stress testing, now on display in Europe, where firms that passed with flying colors folded in the ensuing months. And it puts Weber in good company. But the line is too sharply drawn for my taste. I suspect that assurance and the associated communicative functions—telling investors and voters that all is well, or not—are responsible for the political salience of stress tests, which in turn explains their rise to the top of the regulatory toolkit.

A system that runs on public confidence is hungry for assurance. In this world, stress tests will be used to tick boxes and score political or market points no matter what. In a good state, this can even help fuel demand for regulation. The trick is to figure out how to do stress tests so they provide real assurance—make them dynamic, iterative, multi-dimensional—which requires genuine humility and intense collaboration among regulators and firms around the world, all of whom must change in the process.

This is a tall order and a long path. Robert Weber shows what is at stake, and sets us on the way.


Regulating Financial Innovation

Niamh Moloney, The Legacy Effects of the Financial Crisis on Regulatory Design in the EU, in Eilís Ferran, Niamh Moloney, Jennifer G. Hill & John C. Coffee, Jr., The Regulatory Aftermath of the Global Financial Crisis (International Corporate Law and Financial Market Regulation Series, Cambridge University Press, 2012).

Books sometimes occupy a different ecological niche in legal scholarship than do articles. The fact that books are the main scholarly medium in the UK, while articles dominate in the US, imposes an unfortunate hurdle to communication. Differences in legal regimes and regulatory structures exacerbate the problem. Readers unfamiliar with another jurisdiction’s regime may not be able to appreciate the rich comparative insights that come from evaluating different treatments of shared post-financial crisis regulatory challenges. One of the benefits of a website like Jotwell is that it can help bridge the gaps imposed by geography, institutional structure, and medium, and potentially enlarge the audience for important work that otherwise does not appear online.

Niamh Moloney’s chapter in this book is exceptional in the degree to which it considers financial regulation in terms of regulatory design, as evaluated prospectively. (In the book’s first chapter, coauthor Eilis Ferran lucidly covers existing financial regulatory reforms in the EU. Coauthors Jennifer Hill and Jack Coffee also provide thoughtful chapters, respectively covering why Australia fared relatively well through the financial crisis, and the political economy of Dodd-Frank in the US.)

In her words, Moloney’s chapter “shifts the frame from the first-generation, stability-driven prudential measures which have received extensive attention in the literature and instead examines the spillover or legacy effects of the crisis and the initial stability agenda on the second-generation reforms. It considers whether the crisis has led to productive regulatory innovation in EU market regulation and in EU consumer protection regulation.” (P. 115.) Moloney focuses on the traditional realm of securities regulation – fostering fair and efficient capital markets, or “market regulation”, and consumer protection – in order to understand the torque that the current preoccupation with prudential regulation exerts on these areas. Her concern is a version of that expressed by Ethiopis Tafara in the book’s introduction: that we face decisions, in post-crisis regulatory reform, about where we should extend the traditional tools of the banking regulator, and where we should extend those of the securities regulator (P. xxiv). For Moloney, the question is less where the line will be drawn, than what the spillover effects on the traditional realm of securities regulation will be of the expansive new prudential regulatory agenda.

Notably, Moloney enters the post-crisis financial regulation conversation at what Julia Black has described as the “third level” of regulatory innovation – the cognitive or normative level, producing transformative effects on regulation, paradigm shifts, and a resetting of the policy goals of regulation.1 In particular, Moloney considers the potential impact of an emergent policy suspicion of market innovation and market intensity, with attendant implications for technical regulatory choices and institutional structures. She suggests that this new policy suspicion of market innovation may lead to a “radical and untested resetting” of securities regulation’s traditional policy goals (P. 122).

Moloney canvasses the various ways in which market and consumer protection regulation differ from prudential regulation, and provides an interesting example of the relative importance of regulatory competition in each sphere. She accepts that some resetting of policy goals was necessary following the clear and considerable failures of market regulation that the crisis exposed. She dissects market regulators’ failures carefully, including not only the familiar points about the limits of disclosure-based regulation, flawed assumptions about rationality and market efficiency, and regulators’ inability to understand or respond to risk, but also the fact that securities regulators failed to build on lessons about incentives and internal governance from the Enron era, focusing on research analysts and auditors while not addressing analogous incentives problems across a whole range of financial market actors.

Moloney notes the rise of a new body of post-crisis scholarship that questions the essential social utility of markets. She canvasses the pushback in the EU, at the OECD, and in scholarship questioning the extent to which markets should be completed, and questioning whether or not markets (as opposed to regulation) are able to manage innovation productively. She notes a new skepticism about the goal of promoting innovation in finance at all, a new policy suspicion of self-regulation in general, and a newly strong conviction that regulated actors will always exploit regulatory gaps. In place of the pre-crisis order that favored markets and celebrated innovation, she suggests, is a new “default assumption” that innovation inevitably generates risks, which by their nature require regulatory intervention (P. 137). (Many of us will have noticed this rhetoric in the UK in particular, but the same suspicions appear in the US as well, often in populist terms.) At a meta-level, Moloney suggests the dangers inherent in the current reform movement include risks of international “groupthink”, regulatory over-reaction, the disabling of market mechanisms including trust and reputation, and reliance on international and transnational institutions and networks with poor governance.

Moloney then launches into an incisive and illuminating inquiry into the specific effects of the new normative order, specifically in the EU but concerning questions that are now globally relevant. Through multiple specific examples, Moloney points out the significant expansion of the “regulatory perimeter” of market regulation over a wider range of trading venues (exchanges and other trading platforms) and a wider set of asset classes including fixed income securities and derivatives. She suggests that the moves often entail under-analyzed effects for liquidity, including in the sovereign debt markets. Moreover, extending regulation to a wider range of venues, including the OTC markets, and seeking to apply the same set of rules to this wider set, have both tightened the loosely-regulated OTC space and limited the freedom of regulated entities to self-regulate. While recognizing that high frequency trading seems ripe for regulatory attention, she suggests that HFT-related reforms have acquired momentum by having become a flashpoint in the debate on the social utility of markets overall. Similarly, new efforts to ease capital market entry for SMEs are a convenient but collectively incoherent proxy, fueled by the contemporary concern about the social utility of markets, for the much broader reforms, including to tax policy, that are actually called for.

In the consumer protection sphere as well, Moloney argues that the new suspicion of markets and innovation has prompted UK and EU regulators to consider an energetic new suite of retail market regulatory tools related to what the UK FSA calls “product intervention”, particularly around complex or simply new financial products. Given the regulatory challenges the retail sector presents, Moloney suggests that product regulation may be a promising reform. At the same time, it is an “unwieldy and untested tool” (P. 196) with political and judgmental overtones. It may also have deleterious regulatory effects, particularly for supervisory effectiveness and investor responsibility / choice. Moloney also challenges the automatic assumption that complex products, like synthetic ETFs, are inevitably bad for investors.

Moloney’s careful argument offers a corrective to what she suggests is a collective post-crisis rush to judgment and action. Even for those of us that believe (and Moloney is surely one of them) that financial innovation is neither monolithic nor an unmitigated good, this sophisticated analysis forces us to think more carefully about our reasons for believing so and the actual evidence on which we rely. Particularly in the midst of a highly charged shift in assumptions about the social utility of innovation and markets, we are well advised to look carefully at what we think we know.

  1. Julia Black, “What is Regulatory Innovation?” in Julia Black, Martin Lodge and Mark Thatcher, eds., Regulatory Innovation: A Comparative Analysis (2005), at 9-11. []

Inside the Black Box

Kenneth A Bamberger & Diedre K. Mulligan, PIA Requirements and Privacy Decision-Making in US Government Agencies in Privacy Impact Assessment (D. Wright & P. De Hert eds. 2012) available at SSRN.

Many large law firms are experiencing increased demand for their compliance and risk management services.  They are writing compliance manuals and organizing and teaching training programs.  They compete with consulting and accounting firms for this work.

Some of this work requires skills not traditionally found in law firms.  To be sure, the translation of regulations into simpler language for manuals and the oral communication skills necessary for trainings are commonplace.  But, the best internal controls require knowledge of the pressures on the corporate actor.  And they require understanding the actor’s perspective, in order to motivate their commitment to compliance.  Lawyers known for their “judgment,” often had such knowledge and understandings.  But many lawyers relied on their independence to avoid engagement with what they belittled as “corporate politics and in-fighting.”  Others would rely on their independence to emphasize that they simply gave options to their clients and were not responsible for what their clients did.

Both the forces acting on and the forces emanating from corporate actors must be understood to implement the compliance programs that are evolving as essential features of corporate governance.  Heretofore, corporate governance did not get below the board level.  And, the idea that directors do not direct was repressed, even as it was repeatedly discovered.  If we are going to contribute to compliance and risk management, and if we are train graduates who can compete with those from business schools, then we have to get inside the corporation, which heretofore has been a black box.  We need to understand organizational behavior.

Because of the lack of transparency in corporations, research on their organizational behavior, especially regarding legal compliance, has been limited.  Fortunately, public agencies are large organizations, beset by agency cost problems, and operating more in the sunshine than corporations.  Not all research on public agencies make comparisons to corporations possible, but Bamberger and Mulligan analyze a problem which parallels that of corporate compliance and risk management.

Inside the corporation, compliance activities are “secondary mandates:” the goal of compliance is “at best orthogonal to, and at worse in tension with,” (P. 225) the corporation’s primary economic objective.  They interact with “structures, cultures and decision-making routines geared to maximizing” (P. 226) the corporation’s primary economic mission.

Bamberger and Mulligan examine privacy, a secondary mandate, at two public agencies, US Departments of State and Homeland Security, reviewing their consideration of RFID (radio frequency identification) technologies for passports and visitor and immigrant identification.  They examine how the risks to privacy of this technology, and its consideration in the two agencies’ PIA (privacy impact assessment) interacted with the structures, cultures and processes at the agencies which were geared to efficiency and security, values in tension with preserving privacy.

Bamberger & Mulligan’s goal for the secondary mandate is that the organization “integrate meaningful consideration of” it “into agency structures, cultures and decision-making” (P. 226). The question is not whether the organization will be found to be guilty of non-compliance or even whether the organization is committed to compliance.  Because what constitutes compliance is always contestable (within limits) and because compliance may be in tension with the organization’s primary mandate, a compliant organization is not the appropriate goal.  At best, as the organization’s mission is elaborated, the claims of compliance are meaningfully and seriously part of the organization’s structures, cultures and decision processes.

So understood risk assessment is not the search for hot spots.  Rather, it is the process-based reorientation of decision-making to include compliance values.  For example, Bamberger & Mulligan, similar to those who studied NEPA, discovered that “front-loading” compliance (privacy or environmental) experts into planning processes, led to full consideration of these values as part of decision-making.  In my own work on inside counsel, I too found that their being involved early in the decision making process was critical to their being able to influence decision-making.

So understood, compliance cannot stand separate from or over operations.  Compliance is best effected, Bamberger & Mulligan emphasize, by an “insider:” To operationalize and impact decision-making “requires both an insider’ seat at the policy-making table and an insider position within the day-to-day bureaucratic processes” (P. 240). Otherwise, compliance is likely to be either merely “ceremonial” or ineffective due to information asymmetries.

At the same time, compliance requires that the insider be committed to compliance values – though personal history, expertise or reporting relations.  They must be trusted insiders, but they must not be defined by the culture, structures and processes of day-to-day decision-making.

So, the effective implementer of compliance does not have a “compliance mind-set” (P. 247).  Rather, she is an “expert” on compliance, but for her a “policy orientation” dominates. Her goal is to “ensure the reasoned consideration of” compliance “throughout the” organization (P. 247).  She is not a cop.  She is a go-to expert and shaper of organizational decision-making.

Bamberger & Mulligan clearly show how the management of the privacy compliance experts as the two public agencies resulted in vastly different results, regarding the same technology.  They discuss how the pressures at the agency and on agency personnel interacted with privacy concerns.  In so doing, they have much to teach those who consider compliance at corporations. Bamberger & Mulligan repeatedly term the agencies “bureaucracies.”  Yet, their own evidence suggests that the agencies operate by project-team decision-making, which is characteristic of the modern (de-bureaucratized) corporation.  Their lessons reach further than they think.