Corporate Law

Sharon Gilad

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

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

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

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

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

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

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

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

Caroline Bradley

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

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

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

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

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

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

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

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

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

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

Bill Bratton

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

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

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

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

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

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

Anna Gelpern

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

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

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

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

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

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

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

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

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

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

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

D. Gordon Smith

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

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

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

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

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

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

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

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

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

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

Robert Rosen

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

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

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

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

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

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

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

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

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

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

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

Sarah Woo

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

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

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

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

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

Caroline Bradley

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

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

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

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

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

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

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

D. Gordon Smith

In the late 1990s, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny (“LLSV”) launched a research project examining connections between legal rules governing investor protection and economic development. Working on the assumption that legal rules could be measured and quantified, LLSV purported to demonstrate that common law countries were more protective of outside investors – and, thus, more hospitable to economic development – than civil law countries. In the ensuing years, LLSV and other economists have expanded and refined their work, constructing the grandly named Legal Origins Theory, which holds that legal systems are important determinants of economic development. The influence of Legal Origins Theory is not confined to economics journals, but may be seen in policy reforms through the World Bank’s Doing Business reports.

While many legal scholars have dismissed this work because of its naïve assumptions about law and legal change, especially in early papers, a group of legal scholars at Cambridge University – led by Simon Deakin, John Armour, and Ajit Singh – took Legal Origins Theory seriously. Embracing the assumption that legal rules could be measured and quantified (“leximetrics”), the Cambridge Group produced legally sophisticated datasets on shareholder protection, creditor protection, and labor regulation. In Law and Financial Development: What We Are Learning from Time-series Evidence, published as part of a recent symposium on Legal Origins Theory in the BYU Law Review, four members of the Cambridge Group take stock of what we have learned from those datasets and chart some new directions for future research.

Critics of Legal Origins Theory will not be surprised to learn that the Cambridge Group finds little support for the theory in longitudinal data. While shareholder protections and corporate governance standards have been strengthened worldwide – reflecting the efforts of civil law countries to catch up with common law countries – these legal changes have not resulted in more dispersed share ownership and increased stock market activity, as predicted by Legal Origins Theory. According to Armour et al., these considerable legal reforms suggest that “lock-in through legal origin has not been much of an obstacle to the formal convergence of systems.” More importantly, legal reforms have not led to greater economic development. The authors offer alternative interpretations of their results:

One possible interpretation of our results is that a “one size fits all” approach to corporate governance reforms, stressing elements of British and American practice—the role of independent boards and the market for corporate control—may not be working as intended in civilian and developing systems. Another interpretation is that even in the common law world, shareholder protection can have counterproductive effects, by unnecessarily raising the costs associated with a stock exchange listing.

For those who remain interested in attempts to discern connections between law reform and economic development along the lines suggested by Legal Origins Theory, Armour et al. urge a reconceptualization of the role of legal systems: “legal systems are not the independent, ‘exogenous’ force  that legal origins theory takes them to be. Legal systems are, to some degree, ‘endogenous’ in the sense of being shaped by their economic and political environment.”

The work of the Cambridge Group is an important part of the most significant research advance on corporate governance since the advent of law and economics in the 1970s and 1980s. The analysis by the Cambridge Group has called into question many of the central tenets of Legal Origins Theory, but in my view, the more important long-term contributions of this work are twofold: (1) the work has gone a long ways toward legitimating “leximetrics” in studies of comparative corporate governance, and (2) the work has reignited interest in comparative corporate governance, a field that has traditionally suffered from a perceived lack of rigor.

This may seem a bit hyperbolic, but I believe that this work has paved the way for a re-examination of the whole of corporate law from an empirical, comparative perspective. Such work requires more resources than the traditional corporate law scholarship, but the Cambridge Group has demonstrated the power of leximetrics to provide new insights. One can imagine using these techniques to compare various states in the U.S. or various countries in Europe along any dimension of law that might possibly be related to economic development.

Eric Pan

Poor Delaware.  The small state (45^th in population and 49^th in geographic size) is the dominant corporate law jurisdiction in the United States, and for decades the academic community has been fascinated with the reasons why.  Initially, scholars portrayed Delaware as the savvy champion of a fierce competition for corporate charters.  The quality of its courts, the richness of its case law, and the responsiveness of its legislature made Delaware the most attractive place to incorporate for US public companies.  When Marcel Kahan and Ehud Kamar’s wrote The Myth of State Competition in Corporate Law, 55 Stan. L. Rev. 679 (2002), the academic community’s view of Delaware had changed:  Delaware was not facing direct competition from other states, but rather winning by default.

More so than any other corporate law scholar, Mark Roe has tried to explain why Delaware still has much to fear.  Roe is well known for his argument, articulated in Delaware’s Politics, 118 Harv. L. Rev. 2491 (2005), that Delaware faces a competitive threat from the possibility of corporate governance regulation by the federal government.  Roe’s analysis, originally written in the wake of the Sarbanes-Oxley Act of 2002, has proven prescient with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act last July, which introduced a host of significant corporate governance reforms for US public companies, including say-on-pay and proxy access.

Like the Stephen King of corporate law, Roe is now back with a new set of reasons why Delaware should be afraid . . . very afraid.  First, armed with data on Delaware’s franchise tax receipts and incorporations by companies into Delaware, Roe presents some striking statistics:

• Every year, Delaware experiences a 10 percent turnover in its list of active firms;
• About 70 percent of Delaware’s active firms incorporated in the state only in the last ten years;
• 54 percent of Delaware’s 2008 franchise tax revenues came from firms that incorporated in Delaware in the past ten years; and
• The amount of time it would take for Delaware to lose half of its franchise tax base (assuming no replacements through new incorporations) has shrunk from 25 years in 1983 to only about ten years in 2008.

Thus, Delaware’s position is precarious.  Due to corporate mergers, reorganizations and failures, Delaware’s base of firms decreases at a steady rate.  In order to maintain franchise tax receipts at current levels, Delaware must constantly convince new and existing firms to incorporate or reincorporate in Delaware.  This need to attract new business, even in the absence of active competition from other states for these incorporations, is a competitive pressure on Delaware to invest in improvements to its corporate law regime.

Second, Roe notes that the threat of a new entrant into the market for incorporations is enough to keep Delaware on its toes.  While no state has the same combination of attractive attributes as Delaware, Roe does note that other states do have “toeholds” that could quickly make them viable challengers to Delaware if an opportunity arose.  Roe is fascinated by recent efforts by shareholder activists, like Carl Icahn, to push companies to reincorporate in North Dakota where a lawyer for Icahn and other shareholder activist groups drafted a new corporate law for the state.  But even beyond North Dakota, other toeholds include those states that are developing quite sophisticated jurisprudence regarding the governance of non-corporate business entities and New York with its commercial court system.

Finally, Roe returns to his old theme of the threat posed by federal agencies expanding their efforts to make corporate law.

Roe’s portrayal of North Dakota and other states quietly waiting for Delaware to stumble before making their move would normally generate skepticism.  As Lucian Bebchuk, Assaf Hamdani and others have noted before, the barriers to entry for states to enter into a market for corporate charters are quite high.  But what makes the threat more serious is Roe’s data on reincorporations and the half-life of Delaware franchise tax base.  I do not believe that anyone, other than perhaps those who work for the Delaware Secretary of State, realized how much Delaware relies on a constant flow of new incorporations.  As franchise taxes fund a remarkable 17 percent of the its budget, Delaware cannot afford to let this revenue stream end.

The implication is that Delaware is on the defensive.  Its priorities lie in preventing other jurisdictions from developing advantages that could draw away new incorporations, and there is no incentive for Delaware to go out on a limb with new reforms that could alienate either the corporate managers who make the reincorporation decisions or the institutional investors who may escalate efforts to avoid Delaware.  For those of us who have been critical of various aspects of Delaware corporate law (see, e.g., my paper on problems with the Delaware duty to monitor, available at SSRN), the lesson appears to be to effect change from the outside.  Having federal agencies or other state courts and legislatures consider certain corporate governance reforms may be the best way to get the attention of the Delaware legislature and courts.