Corporate Law

Bill Bratton

Every once in a while I read something and say to myself “this one’s a keeper” in the sense that it goes to the shelf to be drawn on again as an important source of knowledge.  This book earned that status early in the read and it earned it again and again as the read went on.  Indeed, I may be this book’s ideal reader for the very reason that I’m a domestic business law academic.  To be sure, the book follows from and addresses a number of international law literatures and so addresses itself in the first instance to the international legal cohort, both to international law writ large and the group’s business and financial subset.  But the learning curve is much steeper for me than for those primary addressees.  Here we find the whole cast of international financial characters–bankers, cops, securities and insurance regulators, auditors, politicians, bureaucrats, technocrats, and their international and domestic organizations–all carefully and neatly laid out with their histories, structures, and outputs juxtaposed and categorized.  My revelation lay not in the fact that I’d never heard of them (although I must admit that one or two were new to me), but in the fact that my institutional knowledge was full of holes, particularly as regards the book’s comparison to other, treaty-based international organizations.

When I picked up the book I wrote down three general observations, touchstone points to assist in evaluation.  They are:

1. Globalization implies downward regulatory pressure.
2. Soft law will always disappoint you.
3. Reputational sanctions are unreliable.

First, globalization and downward regulatory pressure.  More particularly, what’s the interface between the book’s account and regulatory competition–race to the top, race to the bottom, law as product, or whatever you want to call it?  In fact, there’s not much in the book about downward competitive pressure.  It’s more a background factor that pops up on the screen when pertinent.  Even so, I think it’s an important part of what the book is about.  I think back fifteen years or so to a discourse that posed international regulatory competition as against international regulatory co-ordination. The competition side of the binary was heavily theorized where the co-ordination side was not.  The competition side drew on economic theory going back to Tiebout and had negative things to say about co-ordination, which it cast as rent seeking.  There wasn’t a whole lot on the coordination side.  Since then international lawyers have been slowly filling in the picture.  This is where I locate the book.  For me it fills in the empty set with an exhaustive description of the international co-ordinative effort.  Theory can now start over.

Second, soft law will always disappoint you.  The book does nothing to refute this assertion, even as its author makes his enthusiasm for soft law abundantly clear.  Herein lies another source of value.  Although soft law will always disappoint, there’s no point in railing about its softness when it’s all you’re going to get.  And, says Brummer, international soft law is harder than you think.  The key lies in the capaciousness of the soft law set described.  It is not just IOSCO, or BIS and Basel.  It’s not just the G-20 plus the FSB.  It’s all of them plus the cops at the Financial Action Task Force (who appear to be pretty good at beating up on rogue states), the nasty lenders at World Bank and IMF, and the triumphant standard setters at the IASB.  The cohort, taken as a whole, held out more than enough to reckon with before 2008 and since then it has been very much in motion.  The book’s last part is a tour de force that shows the system in action, sector by sector, in the wake of the financial crisis.  No, these regulators have not solved the problem of systemic risk.  And, yes, their regulatory output very much follows from national-level initiatives.  But national level reforms are all the stronger in light of the cross-border supplement.

Third assertion: Reputational sanctions are unreliable.  This is a point I learned back in the 1980s when American management breached what the law and economics people called “implicit contracts” between corporations and constituents like labor and creditors.  Implicit meant unenforceable at law but to some extent binding in practice.  But the glue came from reputation and management overnight threw out reputational stakes built up across several decades as costs and benefits changed in a dynamic environment.  So I brought a bottomless store of skepticism to the book’s positive case for the binding impact of reputational stakes in international soft law.  I accept the book’s positive case at face value–a constraint is indeed in place.   But for me that only opens the bidding.  That said, I note that the book is unremitting in its discussion of systemic shortcomings.  Although it manifestly makes a case, it does not over-claim.

So if you know all sorts of things about international finance but the entirety remains murky for you, get yourself a copy of Chris Brummer’s book.  Pronto.

Robert Rosen

Many are claiming that the market for legal talent is undergoing fundamental transformation.  If so, there are undoubtedly multiple causes, at the least because the legal market is a highly differentiated one.  In the individual and personal plight sector, user-friendly consumer interfaces and legislative and judicial restrictions on access to justice are of importance.  In the corporate sector, intelligent search engines, outsourcing and the internalization of legal work are of importance.

Today’s changes in the corporate sector of the legal profession, in my opinion, mirror the changes in the engineering profession at the beginning of the last century.  The basic story is that engineering was once a liberal profession, marked by engineers working in engineering firms. Now, although engineering firms still exist, by and large, engineers work inside corporations.  In this transformation, engineers, like lawyers today, lost the monopoly rents which they were able to extract in market transactions between professional firms, which largely controlled elite expertise, and corporate organizations.

To prosper, and to secure jobs for engineering graduates, engineering was forced to redefine what work within the corporation was within engineering’s jurisdiction.  To minimize conflict, the profession articulated how engineering work was to be controlled inside the corporation.  And to regain professional status, engineering graduates became general managers.

Engineering did not only play defense.  Organizational engineering emerged, most famously as espoused by Frederick Winslow Taylor, who had trained as a mechanical engineer. Later, safety engineers, product safety engineers, and security engineers, among others, became career paths within corporations and job choices for those who entered engineering school.  Playing offense, the engineering profession secured more corporate jobs for its graduates than had been available to it as a liberal profession.

Read against this background, Jennifer Arlen’s The Failure of Organizational Sentencing Guidelines, 66 U. Miami L. Rev. 321 (2012), marvelously explains why change in how lawyers serve corporations is necessary and suggests an offensive strategy.  In this article, Professor Arlen continues her earlier work demonstrating that the Organizational Sentencing Guidelines have failed to reach their goal of deterring corporate misconduct and begins to explain how organizational compliance programs can be better designed to detect, report, and respond to non-compliance.

As Professor Arlen has demonstrated previously, sanctions will not deter corporate crime, because sanctioning the organization doesn’t necessarily sanction the responsible individual and the responsible individual is difficult to detect because the organization is relatively opaque from the outside.  Instead, “corporate policing” is required.  For large corporations this creates a challenge:  How to design and implement effective compliance programs?

In this article, Professor Arlen focuses on the perverse effects of the Organizational Sentencing Guidelines on corporate policing.  The Guidelines mitigate punishment for those corporations which have adopted compliance programs.  But the guidelines fail to adequately take into account the increase in misconduct detected by these programs.  Hence, even mitigated, corporations face increased penalties as a result of their corporate policing.

Elegantly using the scoring of the Organizational Sentencing Guidelines, Arlen demonstrates that firms ought not develop compliance systems which include reporting-out if the difference between the probability of government sanction and the probability that the government detects the crime on its own is greater than 30%.  There is little doubt that there is a vast disparity between the government’s ability to threaten sanctions when the evidence is presented to it on a plate and the government’s abilities to ferret out corporate wrongdoing.

Perhaps recognizing this dilemma, in 1999, then-Deputy Attorney General Eric Holder instituted a policy of deferring sanctions (Deferred or Non-Prosecution Agreements) for the implementation of government mandates, the establishment of improved internal monitoring and increased reporting of violations.  This policy recognizes that compliance programs ex ante can reduce the likelihood of crime and ex post can uncover and sanction the responsible individuals.

Arlen applauds this policy but stresses that to be effective this policy requires the government to judge the quality of compliance programs.  But this may be beyond the government’s abilities. We know that agency costs create incentives for managers to portray ineffective compliance programs as effective ones.  And, we know that the government has failed to detect programs that are merely cosmetic.  Our inability to effectively distinguish compliance programs may have led to the inefficient result that Arlen finds:  Government unwillingness to reduce sanctions to levels that reward compliance programs.  Rather than believing that wrongdoing has come to light because the compliance program is effective, government may be as willing to believe that reported wrongdoing demonstrates that the compliance program was toothless.

Arlen suggests that not government mandates but corporate initiatives are required for the design and implementation of effective compliance programs.  At one level, compliance programs may be seen as part of a managerial or accounting task.  Arlen tells us that “directors and managers of large firms need the information and oversight that a good compliance program can provide.”  (n.69, P. 349.)  At this level of abstraction, there is no reason to believe that lawyers have anything special to contribute to compliance programs.

When Professor Arlen focuses on compliance programs, however, she does suggest how the legal profession might battle to include corporate policing within its jurisdiction. First, implementing effective compliance programs requires skills long thought to be typical of litigators, such as investigatory skills before (P. 332) and after violations. (P. 333.)  When violations are discovered, they must be reported to the authorities, with care and precision (P. 331), and then mediation and settlement activities will take place between the organization and the government. (P. 332.)  An effective compliance program also requires education about the law (P. 332) and promoting the values of legal compliance. (P. 331.)  Transactional lawyer skills are relevant for the design (engineering) of compliance programs.  Transactional lawyers are highly attentive to conflicts of interest and these conflicts within an organization often are generators of compliance violations. (P. 331.)  Transactional attorneys are well trained to spot where monitoring is required when the organization supports activities likely to generate conflicted situations. (P. 332.)

On my reading, the takeaway from this article is that government policy does and increasingly will create demand for effective corporate compliance programs and that lawyers can claim that the creation of effective programs is within their jurisdiction.  That is, legal talents are incorporated in the design and implementation of any effective compliance program.

For lawyers to provide the necessary expertise to create effective compliance programs, however, requires changes in how legal work is controlled within the corporation.  In brief, zealous advocates will not design compliance programs that effectively police corporations.  Because litigators have sold themselves as zealous advocates, their presence in the compliance process will be met by suspicion.  This is a serious challenge.  But, I began this piece noting the serious times that face the legal profession.  This is not the place to adequately address this challenge, but let me simply note again that engineering changed how engineers practicing within the corporation were controlled.

Ronald Gilson famously said that lawyers were transaction-cost engineers and thereby made the corporate pie grow larger.  Having followed engineers inside the corporation, lawyers may find themselves becoming organizational legal engineers.  Professor Arlen tells us that designing effective compliance systems will make the corporate pie grow larger.  How else can organizational legal engineers make the pie grow larger?

Professor Arlen indicates that she is now reviewing deferred prosecution agreements to uncover the variety of government mandates and compliance programs that they include.  Her research undoubtedly will uncover other skills necessary for the design and implementation of effective corporate policing. Given the needs of law students, let’s hope some of these skills are lawyerly ones. And that without their work, we can only expect The Failure of Organizational Sentencing Guidelines.

Sharon Gilad

The seminal socio-legal work of Neil Gunningham, Robert Kagan and Dorothy Thornton suggests that social activism is an important influence over firms’ inclination to comply with – and even exceed – regulatory environmental-protection requirements. They further acknowledge that corporations vary in their responsiveness to similar levels of societal pressure, and that the micro-mechanisms underlying this variation require further investigation. Similarly, a recent body of research in sociology and management investigates corporations’ responses to social protest. Yet, much of this literature investigates firms’ average or overall response to social protest, and not the variation among firms. The significance of Weber et al.’s article - From Street to Suits: How the Anti-Biotech Movement Affected German Pharmaceutical Companies – stems from its focus on micro-level analysis of firms’ varied response to social protest.

Weber et al.’s research investigates “how external contestation manifests itself in the internal polity of organizations” (ibid, 109). Their empirical focus is on German pharmaceutical companies’ decisions to invest in the development of biotechnology given an anti-genetic social-movement activism during the 1980s. In order to answer this question, the authors collected press coverage, various primary documents, interviews and secondary sources and produced in-depth portrayal of the social movement and of the responses of six leading German pharmaceutical companies.

Their overall findings and thesis is that the impact of social movement activism on firms’ commercial decisions is a function of the campaign intensity and its mediation by intra-corporate factors and processes. Thus, as a general rule, those firms that were targeted by successful activist mobilization – usually larger firms – were more likely to withdraw from (or to lower their pace of progression in) biogenetic projects. Yet, this overall impact was mediated by intra-organizational conflicts and identity as follows. First, the societal contestation of biotechnology rendered internal champions of the technology less decisive in their fight for their firms’ investment in new research and development due to their concern about damaging their corporate and individual reputations vis-à-vis external audiences.

Conversely, the risk that biotechnology created for firms’ reputations became a sword in the hands of executives and scientists who advocated investing in more traditional –non-biotechnology – pharmaceutical projects. In more diversified firms, which produced not only chemicals but also consumer healthcare products, those advocating investment in biotechnology projects faced particularly high competition from elites with alternative investment agendas.

Second, the social contestation of biotechnology generated uncertainty about its future regulation, and consequently reduced its projected value in comparison with alternative projects.

Third and related to the above, the internal competition within firms and the relative weight given to regulatory uncertainty was further shaped by firms’ organizational identities. Firms which viewed themselves as “core pharmaceutical producers” were more inclined to perceive biotechnology as an inevitable scientific trend, and therefore to give lower weight to societal protest and to regulatory uncertainty in their investment decisions. By comparison, firms which conceptualized themselves as a “diversified business portfolio” were more inclined to forgo investment in biotechnology in favor of alternative projects with more secure financial returns. As a result, large and diversified firms were more likely to withdraw from the biotechnology market or to move too slowly, whereas smaller firms with a core pharmaceutical identity were more inclined to successfully launch new products.

Fourth, the authors illustrate the path dependent impact of firms’ response to social protests. Rather than withdraw from the biotechnology market, some firms chose to shift their production outside Germany or to states (Landers) with less vigorous social opposition and away from their headquarters. As a result, biotechnology teams were physically distanced from the corporate centre, resulting in project coordination problems and in their weaker political position within the firm.

So what is noteworthy about the above findings and conclusions? First, their significance lies in depicting the impact of societal pressure on firms not in terms of gradual normative internalization, as typically suggested by socio-legal scholars, but as a factor that penetrates firms’ commercial investment decisions. Second, they are important in highlighting corporations’ investment decision making as a political process, wherein external societal signals are framed in light of internal struggles over alternative projects. This portrayal diverges from a common tendency to depict corporations as coherent unitary actors. Third, the article shows how corporations’ varied identities mediate their relative openness to external pressures.

Caroline Bradley

Much recent scholarship on financial regulatory reform since the global financial crisis critiques the substance of new standards and rules. For this paper (the draft is dated September 2011) Kimberly Krawiec chose to examine the process which produces rules of financial regulation (this is the sausage-making of the paper’s title). The current administration, like governments of other countries, has emphasized the importance of transparency and open government and of opening up decision-making to citizen participation, so an academic study like this paper, which examines citizen participation in rule-making, is timely and important.

The paper’s case study is of the Volcker rule, which restricts proprietary trading and ownership interests in hedge funds and private equity funds by banking entities. Professor Krawiec chose to focus on the Volcker rule because it “had the potential to illuminate questions of whose voice gets heard on a major issue of financial reform as the sausage is really getting made”. The Dodd-Frank Act left significant discretion to regulators with respect to the details of this rule (and others): key terms and the contours of the exceptions to the bans are not clearly defined. Professor Krawiec explains that the exceptions were a necessary component of a compromise between those who thought that Dodd-Frank should do more to rein in large financial institutions and those who were sympathetic to complaints from financial institutions. She also points out that much of the trading the Volcker rule explicitly permits shares objective characteristics with proprietary trading, such that the motive for the trading is the distinguishing characteristic.

Thus the details of the Volcker rule are being spelled out in administrative rather than legislative processes. The Dodd-Frank Act required the Financial Stability Oversight Council to study and make recommendations on implementing the rule, and in October 2010 the FSOC invited public input to the study via the Federal Register. The invitation produced numerous responses, many of which were based on a form letter produced by a coalition of public interest groups. Professor Krawiec’s study of the letters the FSOC had not identified as form letters (but many of which were) showed that 91% of the 8000 letters sent to the FSOC were form letters. She notes that the number of comment letters suggests that the Volcker rule has some public salience, although the use of the form letter “does not require the same level of investment as the detailed, heavily researched comments submitted by financial institutions and trade groups”. (P. 21.) The comment letters written by private individuals contrast sharply with those submitted by financial institutions and trade groups. Those which were not based on the form letter were short and tended to

lack specific suggestions or recommendations for interpreting and implementing the Volcker Rule… contain many grammatical, punctuation and typographical errors, and express extreme anger at the banks and, often, at the political system as well. (P. 22.)

One result of the governmental insistence on transparency is that the federal financial regulators (including the Federal Reserve Board) have been disclosing information about their communications with the public, including meetings. Professor Krawiec studied available information about meetings between federal regulators and financial institutions, law firms, trade associations and lobbyists and public interest groups. She writes:

In sum, whereas financial industry representatives met with federal agencies on the Volcker Rule a total of 265 times, meetings with entities or groups that might reasonably be expected to act as a counterweight to industry representatives in terms of the information provided and the types of interpretations pressed… numbered only 18. This is roughly the same number of times that a single financial institution–JP Morgan Chase–met with federal agencies on Volcker Rule interpretation and implementation. (P. 27.)

Moreover, nearly all of the small number of meetings between the federal agencies and  public interest and advocacy organizations were group meetings.

In the concluding section of the paper Professor Krawiec is careful not to make dramatic claims about what impact the submissions and meetings had on the development of the regulatory agencies’ thinking about how to draft regulations to implement the Volcker Rule. But the paper raises some important questions about how transparent rule-making processes really are, even in the era of open government.  Proposed Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds (127 pages of them) were published in the Federal Register on November 7, 2011. The proposing release refers to the FSOC study and states that:

Approximately 8,000 comments were received from the public, including from members of Congress, trade associations, individual banking entities, consumer groups, and individuals. As noted in the issuing release for the Council Study, these comments were carefully considered by the Council when drafting the Council study. (P. 3.)

This brief statement gives a very different picture of the comments from the one portrayed in Professor Krawiec’s paper.

Bill Bratton

The GW Center for Law, Economics & Finance, under the leadership of the redoubtable Lisa Fairfax, last spring held its first Junior Faculty Business and Financial Law Workshop. I was one of the old fogies called in to do commentary. It was a successful event. The papers were strong and I was glad of the opportunity to acquaint myself with their authors.

One of the papers has loomed particularly large in the memory—From Graham-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, by Professor Saule T. Omarova of North Carolina Law.

You can see from the title that to take up this paper is to journey into the darkest jungles of banking regulation. Prior to 2008 this was a subject matter of which I was blissfully ignorant. Since then it’s been a forced march through the law and economics of systemic risk and safety and soundness. (I now regularly check into the websites of the Federal Reserve and the Bank for International Settlements.) But, still not having been asked to teach the banking course, I remain hazy on many regulatory nuts and bolts.

That’s where this paper comes in. Professor Omarova takes a sustained look at section 23A of the Federal Reserve Act, a piece of Depression-era legislation that regulates financial relationships between banks and affiliates within holding company structures. The idea is to make sure that the bank, with its deposit insurance subsidy, does not in turn subsidize risky business undertaken elsewhere in the holding company. Section 23A, as originally enacted, worked in tandem with the Glass-Steagall prohibition on investment banking by banks. The paper shows how the section’s operation changed materially when Graham-Leach-Bliley dismantled the wall of separation, and changed again in the wake of the financial crisis.

The operator is the Federal Reserve and the modus operandi is exemption from the section’s operation at the application of a regulated bank. Professor Omarova takes us through decades of Federal Reserve exemption orders. It is amazing stuff. For example, we see Citibank go the well repeatedly. It acquired little nonbanks that churned out subprime mortgages and then, claiming administrative cost savings, subsumed them into the bank (and its subsidy) with the Fed’s blessing. Starting in 2007, as the Fed tore up its own rulebook to spread liquidity, it granted section 23A exemptions of enormous magnitude. Finally, with Dodd-Frank the Congress amended the section, extending its reach.

It is all very complicated, but Professor Omarova makes it intelligible. The journey proves well worth the effort. The author is to be congratulated for digging up the details on this crucial zone of administrative practice and holding the results out for public inspection. The faults are laid bare for all to see. But Professor Omarova is much too astute to cast easy stones. We are told to take the occasion to rethink the whole, asking ourselves what we want out of banking regulation. Unfortunately, as we work our way to that sensible conclusion, we see that the occasion was not taken in the run up to Dodd-Frank.

Anna Gelpern

It is so very lucky that Sarah Woo chose to write Regulatory Bankruptcy: How Bank Regulation Causes Firesales as one article, not the four it could have been. When she died this summer, the legal academy lost a truly original thinker and careful researcher who asked the right questions—and had the knowledge, insight, and judgment to answer them. It is a huge loss.

Regulatory Bankruptcy is the rare article that finds smart answers to interesting questions, which also happen to be good answers to very important questions. The project occupies the intersection of bankruptcy, financial regulation, risk management, and crisis response, and makes theoretical and empirical contributions to each of these fields. I especially appreciate the way in which it helps flesh out the under-studied relationship between law and macroeconomic policy.

The article’s core argument goes to bankruptcy theory: the assumption that creditors seek to maximize individual asset recovery values in bankruptcy cases. Over the years, bankruptcy theorists have argued bitterly over the prescriptive implications of the maximizing assumption—whether it is socially desirable—but barely over the description. More recently, scholars have chipped away at the edges of the description, for example, where securitization or credit derivatives alter creditor incentives.

Woo’s case study goes to the heart of the bankruptcy paradigm: mid-market banks making simple secured loans for commercial real estate development. Her theoretical model suggests that banks, which manage risk on a portfolio basis, may suffer higher losses from asset concentration than from deterioration of individual assets. In their push to reduce concentration (or the proportion of commercial real estate loans in their portfolio), banks will rush to liquidate collateral, such as half-built homes, which would fetch far more if completed. This effect is especially pronounced in an economic downturn, and exacerbated by bank regulation and supervision.

For banking scholars, such findings are only partly intuitive. When bank supervisors press their charges to boost capital adequacy ratios, banks can either raise capital in the numerator, or sell assets in the denominator. The choice between categories and within each category is influenced by regulation and market conditions. For example, if regulators define qualifying capital narrowly, and it is relatively expensive to issue, banks will try to shed assets—especially those that carry high regulatory capital charges, come with supervisory penalties, and can fetch more in the market. In this world, it is perfectly plausible that a bank would choose to sell a “good” asset that has a high regulatory cost.

In Woo’s findings, regulation amplifies the risk management effect. Banks already benefit from reducing portfolio concentration; they benefit even more by responding to supervisory pressure to diversify. A key new twist comes with an economic downturn or a policy change: either or both can create across-the-board pressure on banks to sell assets, leading to fire sales and further depressing prices (bankruptcy contagion). Woo’s addition to financial regulatory literature thus is a mirror image of her bankruptcy contribution: in bankruptcy, she shifts focus from the debtor to creditors as a group; in banking, she illuminates the effects of regulatory policy on debtors as a group, and on other creditors.

If the core argument of the article is innovative, Woo’s execution is especially impressive. She develops her basic model by simulating loss rates in hypothetical bank portfolios with different levels of concentration in real estate construction and development. She finds that under stressed conditions concentration risk could become even more important than individual loan quality in driving portfolio losses, owing to loss correlation. Put differently, a bank with a decent but concentrated real estate portfolio may well lose more in a recession than a bank that made lower-quality real estate loans, but diversified better across sectors. The article proceeds to document a regulatory policy shift beginning in 2006 which resulted in across-the-board pressure on U.S. financial institutions to diversify real estate risk.

The empirical heart of the project is Woo’s analysis of data from real estate developer bankruptcies, combined with FDIC/FFIEC data on portfolio concentration and capital adequacy of the developers’ bank creditors. The hypothesis is that banks with higher real estate concentration ratios are more likely to ask bankruptcy courts to lift the automatic stay, allowing the banks to sell the underlying collateral (unfinished developments). To this un-quant, the analysis suggests pretty persuasively that concentration ratio trumps many other factors in driving bankruptcy fire sales.

The article ends with specific and sensible policy recommendations for bankruptcy reform and systemic risk regulation. More importantly, it helps inform bank regulators of bankruptcy, and bankruptcy judges of bank (and regulator) incentives, with implications far beyond the immediate context of the real estate case study. Woo is remarkably in tune with the latest economics research on crises and macroprudential regulation, yet she goes further to show that legal scholarship–as in her rich account of bankruptcy and banking law in action–has much to teach economists in this area.  Her careful tracing of the ways in which “micro prudence” on the part of individual institutions, risk managers, judges, and regulators can become “macro risk” for the economy is smart, interesting, right, and immensely valuable.

Sarah Woo only just began teaching at NYU last year.  She leaves behind an amazing range of articles, from contracts and project finance to bankruptcy, rating agencies and systemic risk regulation, along with blog and Jotwell contributions. Few people could or would take on the challenges she chose.

I met Sarah once last January, when she presented a version of Regulatory Bankruptcy and commented on other panelists’ papers—except that her commentary came complete with original (“quick and dirty”) data and graphs, which left both beneficiaries and observers momentarily speechless. I have kept her PowerPoint on my desktop, to remind myself of the effort and generosity we owe our colleagues and our audiences.

D. Gordon Smith

Every state corporation statute authorizes the board of directors to issue stock. While one could imagine arguments for allocating this authority to the shareholders, the board of directors is better positioned to respond quickly to financing needs or to provide stock as a motivation for employees. Nevertheless, whenever the board of directors is given an important power, we must be attentive to the potential for abuse. In her new article, The Power to Issue Stock, Mira Ganor reveals various ways in which directors may pursue their own interests at the expense of a majority of the shareholders or thwart the veto power of minority shareholders through the issuance of stock.

Stock issuances are important in Ganor’s account of corporate governance because of the possibility of voting dilution, which occurs when an existing shareholder owns a smaller ownership interest after a new stock issuance. For example, assume that an investor owned one million shares of common stock in Company A, equal to a 25% ownership interest (i.e., the investor owned one million of four million shares outstanding). If Company A subsequently proposed to sell another one million shares to a new investor, the existing investor would see her ownership interest decline from 25% to 20% (she would own one million of five million shares outstanding).

Recognizing this risk of dilution, corporations (especially privately held corporations) sometimes place constraints on the power to issue stock to reassure prospective investors. For example, the number of authorized shares in the corporate charter may be limited or the existing investors may have veto rights or preemptive rights, which would allow them to maintain their ownership interest. In addition, public corporations may be subject to stock exchange listing requirements, which force managers to gain shareholder approval for all new stock issuances exceeding 20% of the outstanding shares.

Despite these potential constraints on the power to issue stock, most publicly held corporations grant the board of directors a great deal of discretion in this area, and boards frequently use that discretion for control purposes. The most familiar example of an issuance motivated by control is the poison pill, which is employed by managers to resist hostile takeovers. Another example is the top-up option, which has become an important mechanism used by managers to facilitate two-step mergers by a favorite bidder. A top-up option gives bidders who acquire a specified percentage of the target company–usually 50%–the option to purchase enough newly issued shares of the target company to reach 90% of the outstanding shares. At that level of ownership, the bidder is allowed to consummate a short-form merger, which does not require a shareholder meeting or a vote of the minority shareholders. Ganor describes the details of the purchase as follows:

Once the bidder exercises the top-up option, she needs to buy the new shares from the company and pay for these shares the same price that she paid in the tender offer. A lower price will not represent a fair market price and may be easily challenged since the tender offer price establishes a fair market price for the shares. [A] large number of shares is issued when the top-up option is exercised, hence the consideration that the bidder should pay the company for these shares is substantial. However, the consideration for the shares can be, and often is, paid with an unsecured note except for a small part, which represents the par value of the shares. Following the short form merger, the unsecured note issued in exchange for the shares is nulled, because after this merger the holder of the note is combined with the issuer of the note and they become one.

Dissenting shareholders may pursue an appraisal remedy after a short-form merger, but their ability to stop the merger seems rather limited. In a case involving a top-up option in the acquisition of Cogent, Inc. in 2010, In re Cogent, Inc. Shareholder Litigation, the Delaware Court of Chancery denied a request for an injunction, reasoning that the harm from the top-up option was too speculative. The plaintiffs in Cogent argued that the top-up option was a sham transaction because the note offered in consideration of the option shares was “illusory consideration,” but Vice-Chancellor Parsons was deferential to the board of directors, concluding that the Delaware code “leaves the judgment as to the sufficiency of consideration received for stock to the conclusive judgment of the directors, absent fraud.”

Top-up options provide an excellent illustration of the agency problems that may arise from the power to issue stock. The most original and important contribution of this article is Ganor’s attempt to capture the potential for abuse with the “excess-ratio,” which is the ratio of authorized non-outstanding shares to the issued and outstanding shares. Ganor observes:

[A]n excess-ratio of one signifies that there are enough authorized but not outstanding shares to double the number of shares already issued and outstanding. The stock exchanges‘ requirement of shareholder approval for an increase of more than 20% of the issued share is equivalent to a 0.2 excess-ratio; and the German limit of 50% can be expressed as a 0.5 excess-ratio.

Ganor concludes her paper with some limited empirical evidence on the excess-ratios of non-financial companies incorporated in Delaware that have completed an initial public offering in the United States. While the ratios seem high–with reported means in excess of 5 and reported medians typically between 3 and 4–Ganor found no meaningful correlations between the ratio and firm size or between the ratio and the likelihood of acquisition.

This paper focuses our attention on an aspect of director power that is rarely acknowledged in the vast literature on managerial agency costs. Ganor offers useful descriptions of the manner in which the power to issue stock can be problematic, and she takes the first step toward systematically analyzing that power.

Robert Rosen

Donald Langevoort demonstrates, again, his ability not only to do behavioral economics but also to reframe it by placing actors in organizational contexts and relations.   Behavioral economics, sharing economics’ methodological individualism, analyzes biases and cognitive heuristics in regards to individual risk taking.  More broadly, social psychology investigates decision effects that result from affects, visceral and cultural factors, as well as pressures toward or against groups and authority. For example, Solomon Asch emphasized that people make decisions in public differently than they would in private, based on their impressions of others, and seeking legitimacy.¹ Langevoort presents research that builds on Asch, for example the finding that in the presence of an audience, facing rivals, with time pressure to make a mark, individual motivation may shift from goal attainment to an obsession with winning at all costs.² Such work not only uncovers other sources of bias, but also it reframes the subject as decision-making rather than only risk-taking.  In “the ‘competitive arousal’ model of decision making,”³ the actor doesn’t engage in risk analysis, rather other motivations and models engage the actor.  For some it is Tversky or Asch.  Langevoort learns and masters work in both traditions, and more.

Langevoort’s subjects are the decisions that led to the Global Financial Crisis (GFC) and what gatekeepers need to learn from it.  A principal-agent approach to the GFC demands explaining excessive risk-taking by theoretically risk-averse employees (invested in and frightened of losing their jobs).  Although he has proffered other explanations, in this article, Langevoort focuses on the firm’s shaping of actor’s understandings and motivations.  A principal-agent approach normally addresses the design of appropriate contracts, incentives, compensation and monitoring systems.  In this article, Langevoort focuses on understanding the firm’s organizational culture.

Langevoort proposes the functionality to firms of employees being unrealistic and overconfident, able to deflect doubt and sometimes taking unjustified risks.  “He who hesitates is lost” is an adaptive mindset for a firm in a competitive environment.  In analyzing reports from the GFC, Langevoort draws out a wide range of aspects of firm culture, including routines, myths, scripts, rationalizations, fraternity-like excess, ideologies, and sense-making perceptions and inferences.  With such a developed understanding of corporate culture, Langevoort might have added that there are multiple cultures in any organization and the adaptive one on which Langevoort focuses may be joined to others, such as the one that might be carried by gatekeepers, inscribing “Look before you leap.”

Langevoort advises gatekeepers that they need to understand organizational culture.  Of course, one result is that gatekeepers will understand not to believe everything presented to them.  Understanding organizational culture importantly reveals that it is not normally the case that misreporting is the result of deception.  The misreporting is scripted in firm culture and makes sense to its participants.  Langevoort advises gatekeepers not to challenge the risk-taking culture (no “Fools rush in where angels dare to tread”), emphasizing that awareness of the culture will teach when objectivity must be sought.

Despite Langevoort’s analysis, at points he is unwilling to move beyond methodological individualism.  He says that the issue is what “might bias the assessment of financial, legal, and reputational risk.”(P. 30.)  He says he is only “project[ing] individual cognitive biases into the larger organizational culture.” (P. 12.)  Yet, at other points, he speaks of culture as “making it hard to perceive the need to rethink,” (P. 24), or providing “deeply held cultural ideologies” (P. 26.)

There are at least two reasons why it is difficult to move beyond risk-taking as the description of decision-making, neither of which I can do justice to here.  The first is that understanding decisions as risk analysis enables experiments and theory development, even as it eclipses the actor.  On the other hand, one of the joys of Langevoort’s work is that the actor peeks through.  In my understanding, to an organizational actor, the choice is not always (or normally) which of a well-defined set of options to choose.  The choice is “What shall I do.”  The organizational actor is immersed in actions and in culture.  Facing decisions, she solves problems.  Of course, she uses evidence and assesses probabilities.  But, as she conceives them, intelligence and imagination are her normal tools for decision-making, not risk-analysis.  Inscribing the actor within the broader understanding of decision-making may be noisy, but has its charms.

The second reason why it is difficult to move beyond risk-taking is an identification of risk-taking with corporate behavior.  One indication of this is that risk management has become the regulatory response to the GFC.  This article is relevant to corporate law because gatekeepers (including the board) are increasingly tasked with assessing financial, legal, and reputational risk.  This focus on risk management occludes that “risk” has multiple meaning (or that uncertainty differs from risk) and treats all business as if it were the casino capitalism that led to the GFC.

What does the failure to hedge against systemic risk in the CDO market tell us about, say, the decision to chance violating emission discharge laws by a manufacturer?  If by legal risk we mean the risk of getting caught and paying a fine greater than a certain sum, then everyone may be in a casino (and ignoring ALI Principles of Corporate Governance §2.01).  But, decisions are more complex than that and involve commitments, character and cultures.

Failing to recognize that risk-taking is one part of decision behavior and failing to recognize what appears as a risk may be a predicate to self-defining choices leaves us understanding all of business as casino capitalism.

By inviting both Tversky and Asch, Langevoort invites deeper understandings.

1. S.E. Asch, Effects of group pressure upon the modification and distortion of judgments.  In H. Gustzkow (ed.) Groups, Leadership, and Men 177-190. Pittsburgh, PA.: Carnegie Press (1951); Asch, S. E., Forming impressions of personality, 41 J. Abnormal and Social Psychology 258-90 (1946); Asch. S.E., The doctrine of suggestions, prestige and imitation in social psychology, 55 Psychological Review 250-276 (1948). [↩]
2. Langevoort, note 42. [↩]
3. Langevoort uses this phrase, drawn from G. Ku et. al., Towards a competitive arousal theory of decision making: A study of auction fever in live and internet auctions, 96 Org. Behav. & Human Dec. Processes 89 (2005), cited in Langevoort at n. 42. [↩]

Sarah Woo

As we try to learn the right lessons from the 2008 financial crisis, a debate has emerged as to the merits of bailouts versus bankruptcy. Although the chaotic days when Lehman and AIG were failing are starting to fade into financial history, ongoing news on European bailouts reminds us that this debate is still very much alive.  Bankruptcy or Bailouts by Kenneth Ayotte and David Skeel, provides an excellent Law and Finance discussion that unpacks the key issues of moral hazard underlying rescues of financial institutions and the systemic risk considerations. They identify cases where bankruptcy has been surprisingly effective, discuss how it avoids various distortions resulting from bailouts, and challenges the common view that Chapter 11 bankruptcy is an inappropriate vehicle for resolving distress in financial institutions.

This article confronts head-on the difficulties in this area – the difficult choices for policymakers, and the difficulty in establishing causality between past events (e.g., the Lehman filing and the AIG bailout) and the volatility and illiquidity in the market. As Ayotte and Skeel remarked, questions such as whether a Lehman rescue loan could have reduced the severity of the financial crisis that followed are “impossible to answer with certainty.” (P. 490.) They then proceed to present some data, which provides us reason to be skeptical about the conventional wisdom that Lehman’s Chapter 11 filing was the singular cause of the resulting credit crunch.

Given these difficulties, it is interesting to contrast this article with another recent paper, In Defence of Bailouts, by Adam Levitin, where systemic risk is described in terms of political accountability and legitimacy. It appears that Ayotte and Skeel differed from Levitin on whether moral hazard and systemic risk are minimized (or can be minimized) in a bailout versus in bankruptcy. In particular, Levitin argued that a bankruptcy court may not be capable of deciding upon (and enforcing) the politically acceptable distributional outcome, especially if there are systemic implications. This is consistent with what George Akerlof and Robert Shiller opined in Animal Spirits (2009) – that the creditors’ focus in bankruptcy proceedings is mainly on the institution in question and there needs to be a reconsideration of bankruptcy law to take special account of the fact that the public has an interest in such distress situations.

Nonetheless, the article by Ayotte and Skeel has complicated the usual assumption that nothing good can come from the bankruptcy of a large financial institution through an examination of the firm-specific costs, corporate governance distortions, and downsides of the prompt corrective action approach by regulators. They have made a convincing argument that the bankruptcy regime should play a role in resolving financial institution distress with a handful of changes, especially those pertaining to derivatives. There is, however, an open issue that we are reminded of by their article: the 900,000 derivative contracts to which Lehman was a counterparty. An issue, seldom discussed in this debate but one that can affect our assessment of the choice between bankruptcy and bailouts, is the extent of public disclosure in bankruptcy, as compared to bailouts. Just as a bank’s supervisory CAMELS ratings are kept confidential to prevent a bank’s customers and investors from losing confidence and potentially mounting a bank run, significant counterparty exposures to financial institutions disclosed in bankruptcy dockets could have spillover effects in terms of affecting market confidence in these counterparty institutions.

Flexibility and open-mindedness would seem to be the best course, and this is a recurring theme in this article. Ayotte and Skeel have adopted a realistic position in stating that “[i]f regulators conclude that systemic risk concerns are so great that intervention is necessary, [regulators] could use an intermediate strategy of allowing the firm to file for bankruptcy, while selectively guaranteeing certain ‘dangerous’ liabilities as an alternative to a rescue loan.” (P. 491.) At the end of the day, Ayotte and Skeel are essentially advocating Bankruptcy 2.0, where there may be pockets of government intervention alongside the bankruptcy regime, as opposed to the oft-cited view of bailouts without bankruptcy being an inevitable part of modern financial markets.

Caroline Bradley

The transnational transmission of risk is increasingly visible as a subject of policy debate, from transnational terrorism to global warming, from food safety to the financial crisis.  These risk transmissions involve more fundamental security risks: for example, the global financial crisis has led to violent protests; low-lying states are threatened by rising water levels; populations facing issues of food security also have implications for security and stability more generally.  As these risks become increasingly recognized, international and transnational law, and also international standards, are increasingly relevant to US-based businesses. Private firms are affected when states enact and propose rules to address risks to global security, such as the SEC’s recent proposals for disclosures about the use of conflict minerals.

Our standard model of the impact of treaties (and agreements setting non-binding standards such as those developed by the Basel Committee) on non-state actors involves implementation through domestic legislation.  However, in this article Natasha Affolder argues that corporations engage with environmental treaty norms in ways that this standard model fails to reflect.  Instead, corporations interact with treaty norms directly and via the transnational standard-setting process.  Thus, she challenges the traditional model of treaty implementation and the usual separation between public international lawyers and scholars of private governance.  At the same time her article has implications for those of us who study the legal environment within which businesses operate, and illustrates a complex set of interactions between governmental and non-governmental bodies around environmental regulation and practices.

Affolder suggests corporations’ interactions with and translations of treaty norms may in fact produce changes in the underlying treaty obligations.  In some cases corporate action may undermine treaty commitments:

In translating treaty norms for corporate use, companies cherry-pick among treaty provisions, interpret treaty commitments in their least onerous forms, and obscure the ways in which corporate activities impede treaty implementation by selectively reporting on instances where corporate policies and actions advance treaty norms.

But in some contexts, Affolder recognizes that corporate action may “lead to stronger and deeper implementation of treaty norms.”

The article focuses on environmental treaties, although Affolder suggests that the implications of “corporate channeling of treaty meanings” are broader.  She would extend the implications to human rights and labor, and I think that her work is also relevant to financial regulation.  The global financial crisis led to new efforts to reform financial regulation among domestic, regional and international policy-makers.  The Basel Committee has developed Basel III , the EU is reforming its structures for financial regulation, and the US enacted the Dodd-Frank Act.  But financial firms and the trade associations which represent their interests are also involved in developing the new rules, through efforts to lobby across borders, arguing that rules applied in one jurisdiction should not be more onerous than those in others, and through the development of private standards.  In October, staff of the IMF wrote that “private sector ownership of the financial reforms will be key to the successful implementation of the new rules”.

Affolder’s article is important, and nuanced.  Corporate action in translating and implementing treaty provisions is neither entirely positive, nor entirely negative.  Affolder does not offer a new theory — but this is the point: she pushes us to face the complex and multivalent facts about the interactions between business and law in a world of multi-level rules.