Demystifying the Fed

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

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

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

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

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

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


Managing Global Supply Chains: Coca Cola and Sugar in Brazil

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

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

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

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

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

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

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


Justifying Fiduciary Law

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

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

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

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

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

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

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

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

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

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

Cyber Finance Considered

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

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

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

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

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


Stress Renaissance

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

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

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

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

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

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

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

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

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

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

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

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


Regulating Financial Innovation

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

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

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

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

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

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

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

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

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

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

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

Inside the Black Box

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

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

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

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

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

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

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

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

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

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

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

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

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


The Business Case for Corporate Social Responsibility

Robert G. Eccles, Ioannis Ioannou, & George Serafeim, The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance, Harvard Business School Working Paper 12-035 (2012), available at SSRN.

Progressive corporate law scholars have tended to ignore business or economics research as potential support for their normative claims.  When seeking interdisciplinary insights they have generally looked elsewhere.  This is not surprising, given that business and economics scholarship often reflects assumptions about corporate law that progressives reject, in particular a shareholder primacy orientation that prioritizes shareholder wealth maximization while disregarding social costs.  For progressives, business and economics scholarship may also bear the taint of its embrace by mainstream corporate law scholars, many of whom have a strong law-and-economics, empirical perspective that draws them naturally to finance, accounting, and management literature.

Those interested in corporate social responsibility (CSR) and the problems of managerial and investor short-termism should not overlook the paper reviewed here.  Robert Eccles, Ioannis Ioannou, and George Serafeim (professors at Harvard, London, and Harvard business schools respectively) make an important contribution to debates among corporate law academics about CSR as an alternative to shareholder primacy.  Their paper also has significant relevance to those who are concerned about the costs of shareholder primacy’s current incarnation as an obsession with quarterly earnings and their effects on share prices.  The authors present a sophisticated, empirically grounded demonstration of the economic advantages enjoyed by corporations that have chosen to invest in stakeholder relationships and to pursue a long-run approach to wealth creation.  Because these companies are shown to outperform financially their more traditionally-minded, shareholder-primacy, short-term-oriented rivals, CSR advocates can assert a ‘business case’ for their belief that corporations should attend to the well-being of nonshareholding stakeholders, including employees, customers, local communities where the firm operates, and those who are affected by its impact on the environment.  The business case also lends support to critics of short-termism who have no particular interest in CSR.

A persuasive ‘business case’ for CSR is important because until now the large body of empirical research investigating its efficiency has yielded distinctly mixed results.  Further, the ‘ethical case’ for CSR gains limited traction among investors and managers seeking to maximize financial returns.  Progressives do need to bear in mind the limits of the business case:  it justifies investment in stakeholder well-being only to the extent that there is a financial payoff.  Nevertheless, there is no doubt that companies genuinely embracing a stakeholder orientation create more social value than those that do not, even if their motivation is primarily economic.

Eccles and his colleagues identify 90 corporations that adopted a range of social and environmental policies in the early 1990s.  These are referred to as the ‘High Sustainability’ (HS) firms because they invest in and nurture valuable stakeholder relationships in order to create financial gains sustainable over the long run.  They integrate these policies into their business models rather than merely paying lip service to CSR as a marketing strategy.  The authors then match these firms with 90 others, each closely comparable to its HS counterpart in sector, size, capital structure, operating performance, and growth potential.  The second group – the ‘Low Sustainability’ firms – pursue a traditional commitment to profit and share price maximization, disregarding externalities where cost-effective to do so.  Their short-term orientation discourages even stakeholder expenditures that promise long-term payoffs because of the immediate negative impact on accounting results.

Having constructed these two sets of firms, the authors draw on third-party proprietary databases that analyze the extent to which particular companies have embraced various sustainability practices and policies.  The point is to assess the extent to which the corporate culture of the firms that embarked on a sustainability path truly is different today from that of their traditional, LS counterparts.  The authors find substantial, often dramatic differences.  As to governance, for example, HS firms are much more likely to assign explicit responsibility to the board of directors or a specially tasked board committee to advise and to monitor senior management on sustainability issues.  The compensation of senior executives is more often linked to environmental and social metrics, in addition to the more typical financial ones.

Because a commitment to sustainability requires stakeholder engagement in order to understand needs and expectations and develop effective responses, HS firms tend to adopt mechanisms that are unusual at LS firms.  These include processes for facilitating and collecting expressions of concern, such as grievance mechanisms, and for reporting responses to stakeholder issues to the stakeholders themselves and to the public.  HS firms ‘are more focused on understanding the needs of their stakeholders, making investments in managing these relationships, and reporting internally and externally on the quality of their stakeholder relationships.’ (P. 17.)

Commitment to sustainability also requires a long temporal horizon because development of robust stakeholder relationships requires trust based on effective cooperation over time.  It also requires expenditures that reduce earnings in the short-term – such as employee training, infrastructure investments in developing countries, and customer service – while generating payoffs only in the future.  Eccles and his co-authors find evidence of a long-term orientation among HS firms in comparison to their LS counterparts by analyzing the language used in conference calls with stock analysts.  They also find higher percentages of shares owned by ‘dedicated’ or patient shareholders as opposed to ‘transient’ or high portfolio turnover investors.  As with internal governance and stakeholder engagement, the point here is that the companies that embarked on a sustainability path in the early 1990s had by 2010 developed distinctive cultures that set them apart from their LS counterparts in a number of significant, substantive ways.  The differences go far beyond mere ‘greenwashing’ or ‘cheap talk.’

Having shown in detail the significant cultural differences between the HS and LS firms, Eccles and his colleagues then compare their financial performance, using both share price and accounting metrics.  These findings are likely to draw the greatest interest and attention.  The cumulative stock market performance of the HS firms from 1993 through the end of 2010 is significantly stronger:  $1 invested in a value-weighted HS portfolio would have grown to $22.6, versus $15.4 for a LS portfolio.  Equal-weighted portfolios would have yielded similar differences.  Accounting measures likewise indicate superior performance.  Using return on assets as the metric, $1 invested in a value-weighted portfolio of HS firms would have grown to $7.1 compared to $4.4 for a LS portfolio.  Similar results are derived using return on equity.  The authors’ conclusion is a bold one:  ‘companies can adopt environmentally and socially responsible policies without sacrificing shareholder wealth creation.  In fact, the opposite appears to be true: sustainable firms generate significantly higher profits and stock returns, suggesting that developing a corporate culture of sustainability may be a source of competitive advantage for a company in the long-run.’ (P. 30.)

The implications of this study for corporate law are important.  It often seems as if corporate law progressives and mainstream law-and-economics proponents talk past each other with no basis for engagement.  It is as if those concerned about the social costs of corporate activity have nothing to say to those focused on maximization of shareholder wealth.  A persuasive, empirically grounded business case for CSR can change that because it allows corporate law progressives to justify attention to nonshareholder considerations in economic rather than purely ethical terms.  The duties of directors and senior officers therefore might more readily be defined as embracing a range of stakeholder interests, rather than in terms of shareholder primacy.  The case for management’s ability to deploy defensive measures against hostile takeovers may also be strengthened.  Takeovers can threaten long-run business strategies for the sake of short-term shareholder gains.  However, this paper also suggests the need to interrogate target management claims.  All firms are not equal with respect to genuine commitment to long-run, sustainable business models.

The results presented in this paper also have important implications beyond the divide between proponents of CSR and shareholder primacy.  At the moment, a shareholder empowerment agenda enjoys strong support in legal academic as well as business circles.  The idea is that shareholders should be better able to pressure management to act in their interests.  I have written elsewhere about the propensity of many large institutional shareholders, including public and private pension and mutual funds, to focus their investment strategies on short-term, quarter-to-quarter gains.  This is a function, in the case of pension funds, of their current legal obligations to their beneficiaries and, in the case of mutual funds, of competition for investor dollars.  The paper under review here warns us that empowering these shareholders could threaten business strategies capable of creating long-run economic value that exceeds what can be realized from a focus on quarterly profits.  Shareholder empowerment, in other words, would yield financial as well as social costs.  Beyond its value as a response to the shareholder rights activists, this paper also lends strong support to arguments for proactive law reform aimed at curbing short-term investment and management horizons.  In sum, here is a paper, empirically grounded and produced by business school researchers, that should be of great interest to corporate law scholars skeptical of shareholder primacy or concerned about short-termism.


Why Would the Social Behavior of Good Firms Improve and that of Bad Firms Worsen?

Brayden King & Mary-Hunter McDonnell, Good Firms, Good Targets: The Relationship Between Corporate Social Responsibility, Reputation, and Activist Targeting, in Corporate Social Responsibility in a Globalizing World (2012), available at SSRN.

The global financial crisis fueled public discontent with the economic and political outcomes of capitalist regimes. This caused a mistrust of large businesses, with outrage towards the multinational banking sector in particular. It is therefore no surprise that corporations are increasingly the targets of mass social protests. To take a few prominent examples, in the US, the Occupy Wall Street movement has been challenging the legitimacy of American capitalism, and demanding a deep transformation in the relationship between government, corporations, and the public. In Spain, against a background of skyrocketing unemployment rates, the 15-M Movement has been calling into question the distribution of political power and institutionalized corruption. At the same time, in Israel, unprecedented mass protests during the summer of 2011 called into question the excessive market power of conglomerates, the high cost of basic necessities, and the contraction of the welfare state. These instances of mass social protest pose a threat to corporations’ and public agencies’ legitimacy, reputation and smooth operations.

How do corporations respond to, and manage, the threats imposed by social activism, and what are the consequences of their strategies? One would expect, and indeed hope, that democratic pressures – i.e. social activism – would render irresponsible corporations more responsive to societal expectations and demands. And second, we would like to think that social activism is targeted at irresponsible firms, whereas socially responsive and responsible corporations are rewarded inasmuch as they are less likely to be targeted by activists. King and McDonnell investigate the latter expectation and find that precisely the opposite is true.

Specifically, they outline and test two competing hypotheses, which they label “the reputational halo effect” versus “the reputational liability effect.”  The former hypothesis predicts that firms that engage in more pro-social activities and/or those with positive reputations are less likely to be targeted by social activists. Their good reputations and social deeds act as a shield that protects them when things occasionally go wrong, or at times of general social upheaval.  The rival hypothesis suggests that corporate social responsibility (CSR), and/or positive reputations more generally, increase a firm’s risk of being targeted by social activists. The authors’ statistical analysis demonstrates that firms’ likelihood of being targeted by activist boycotts increases with higher levels of CSR  engagement (measured in terms of CSR announcements in the 6 months prior to a boycott), as well as with more positive pre-boycott reputations. Namely, good reputations and CSR activities act as a liability and not as a shield. The finding that a more positive reputation, which first and foremost reflects a firm’s profitability and commercial success, increases the firm’s likelihood of being targeted by activists should come as little surprise or concern, as we already know that social movements seek to enhance the impact of their campaigns by targeting visible and reputable firms. However, the finding that a firm’s pre-boycott announcement of CSR activities increase its risk of being targeted is more surprising and troubling (unless we think that CSR announcements are a poor predictor of a firm’s actual pre-boycott behavior, and that activists astutely see through corporate rhetoric).

The implications of the above findings, as outlined by the authors, are that socially responsible firms are more likely to attract social pressure, and consequently to further increase their already high CSR investment (and hopefully not just their CSR rhetoric). By comparison, irresponsible firms are paradoxically less likely to attract social activists’ attention, and are consequently under little pressure to improve their poor social performance. This seems like a normatively unsatisfactory outcome, which calls for consideration by social activists as well as for further research.


An Unexpected Remedy: Eminent Domain as a Potential Solution to the Mortgage Crisis

Robert Hockett, It Takes a Village: Municipal Condemnation Proceedings and Public/Private Partnerships for Mortgage Loan Modification, Value Preservation, and Local Economic Recovery, 18 Stan. J. L. Bus. & Fin. (forthcoming 2012) available at SSRN.

It is quite rare to come across a law review article that offers not only a theoretical diagnosis of a major socio-economic problem but also a plan for solving that problem in practice.  Putting forward a real, well-reasoned, and detailed policy proposal is always an act of scholarly courage, which inevitably exposes the author to all kinds of criticism.  This is especially true where the proposal targets a complex issue in which stakes are high, arguments are heavily ideology-driven, and powerful special interests dominate the agenda. Robert Hockett’s recent essay takes on precisely such a controversial issue: the nation’s continuing problem with underwater mortgages.  Since it was posted on SSRN several months ago, this essay has been making serious waves in policy-making circles (and earning its author no love from Wall Street).

Hockett starts with an incisive diagnosis of the root causes and structural dynamics of the mortgage crisis plaguing the nation since 2007. Five years after the bursting of the latest real estate bubble, mortgage debt overhang continues to be one of the primary factors impeding broad economic recovery in the U.S. and, consequently, globally. As Hockett argues, underwater mortgages – or loans on which the homeowner owes more than the current market value of the house – function as the principal drag on the U.S. housing market and the entire economy. Homeowners whose mortgages are underwater default at accelerating rates, leading to mass foreclosure, property degradation, and consequent asset devaluation. Moreover, such homeowners also don’t spend their money on purchases of goods, which depresses the consumer demand that is so vital to a robust economic recovery. According to Hockett, as of the beginning of this year, nearly a quarter of all mortgages in the U.S. were underwater, with an even higher concentration of underwater loans in certain especially hard-hit counties and cities. In effect, these are the loans that, while not technically in default, teeter on the edge of the abyss – and the more of them fall, the wider that abyss gets. Hockett argues that the only practical long-term solution to this problem is to write down the principal on underwater mortgages to post-bust market value levels.  That would effectively force the necessary adjustment in asset values and erase the crippling legacy of the pre-2007 real estate bubble.

Yet, so far, nothing has been done to implement this solution. Focusing primarily on private-label mortgage securitizations, Hockett identifies key structural obstacles to principal write-downs of underwater mortgage loans.  Thus, multiple investors in mortgage-backed securities suffer from a classic set of collective action problems and require collective agents – trustees or loan servicers – to act on their behalf. Unfortunately, the typical pooling and servicing agreements (PSAs), drafted during the irrationally exuberant bubble years, prohibit or effectively prevent modifications of mortgage loans, even where such modifications would bring down the loan-to-value ratio and potentially increase the market value of such loans.  The essay contains a thorough and lucid description of numerous built-in market dysfunctions and conflicts of interest among various market actors.  It is a logical conclusion, then, that the government is the only potential collective agent capable of overcoming such conflicts and contractual impediments.  Indeed, the core of Hockett’s argument is that the government has to use its constitutional powers of eminent domain to force write-downs of underwater mortgages.

Skeptical of the federal government’s political will to act to that end, however, Hockett proposes that state and local governments take the lead in this area.  He calls for states and municipalities – townships, cities, and counties – to exercise their eminent domain authority to take over underwater mortgage loans, compensate bondholders for the fair value of such loans, and then modify the loans by writing down the principal.  Not surprisingly, this is where the proposal makes many readers at least somewhat uneasy, if not outright hostile to the entire thing. Yet, they should stay with Professor Hockett as he patiently and eloquently takes them through the intricate details of his plan and explains how it complies with all constitutional limitations on exercise of a sovereign’s eminent domain authority. He dispels common confusions and misunderstandings of the relevant law and builds a convincing case for eminent domain as a “win-win” solution that would ultimately benefit everyone: homeowners, holders of mortgage-backed bonds, communities, and local and regional economies.

Of course, it is impossible to do justice to such a complex proposal in a few short paragraphs. It is also difficult to predict whether this creative and elegant plan will, in fact, become the blueprint for widespread local and state government action. Yet, the increasingly heated debate on the merits of Professor Hockett’s ideas and the apparent mobilization of various interests opposing (or, conversely, supporting) his plan suggest that it may well become such a blueprint. In any event, this essay is a must-read for anyone interested in financial markets and regulation.