A New Theory of Insider Trading Law

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

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

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

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

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

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

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

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

 
 

Drama and Consequence in Accounting Standards Choice (Seriously)

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

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

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

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

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

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

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

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

 
 

New Law School Fields of Study: Compliance and Risk Management

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

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

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

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

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

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

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

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

 
 

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.