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.


Costing Financial Regulation

Bruce R. Kraus & Connor Raso, Rational Boundaries for SEC Cost-Benefit Analysis, 30 Yale J. on Reg. (forthcoming 2012), available at SSRN.

Debates about the costs and benefits of regulation, and about particular rules, are a very visible feature of lobbying about proposed financial regulation and of challenges to final rules. Industry opposition to the Dodd-Frank Act has focused on arguments about the costs of regulations envisaged by the Act. For example, in the summer of 2012 the US Chamber of Commerce Center for Capital Markets Competitiveness published a report by Anjan Thakor on the Economic Consequences of the Volcker Rule which argued that the rule would adversely affect bank customers as well as banks. The report argued that reductions in the risk of banking and of costs to taxpayers could be achieved “with greater efficiency by making judicious use of capital and liquidity requirements.” Senator Richard Shelby introduced the Financial Regulatory Responsibility Act of 2011 (FRRA) in Congress with a promise that it would hold “financial regulators accountable for rigorous, consistent economic analysis on every new rule they propose.” Bruce Kraus and Connor Raso are concerned that the SEC’s ability to regulate, and even to carry out its mandates under Dodd-Frank, will be severely compromised by these developments.

In this paper Kraus and Raso argue that, by failing to provide its own interpretation of the National Securities Markets Improvement Act’s requirement that the SEC consider the impact of its rules on “efficiency, competition and capital formation,” the SEC allowed commentators and the courts to define the agency’s obligations with respect to cost-benefit analysis. The authors critique court decisions which have addressed the SEC’s obligations to consider the impact of its rules on “efficiency, competition and capital formation,”(in particular Business Roundtable v SEC), and argue that the SEC should now “affirm its substantial and long-standing expertise in financial economics, and insist on the agency’s right, derived from that expertise, to discern and define the boundary between economic analysis and policy choice.” Kraus and Raso discuss the SEC’s composition as a multi-member, bi-partisan agency which must, as a result, engage in compromise, even log-rolling, although its ability to do so is compromised by the Sunshine Act. The structure of the SEC is thus important in thinking about how the SEC should act, and the authors argue that the requirement that the SEC engage in cost-benefit analysis should not be interpreted to “invalidate the predictable results of such a system.” Kraus and Raso approve of the SEC’s March 2012 issuance of Guidance on Economic Analysis in SEC Rulemakings, but they urge the SEC to think of “involving economists more completely in the policymaking process” as more than “a procedural change.” They argue that “the economic analysis will be more compelling if it influences (rather than merely describes and rationalizes) the substance of the rule.”

As Kraus and Raso recognize, the SEC’s composition has led to Commissioners making public statements on the adoption of final rules, often invoking arguments about inadequate cost-benefit analysis. For example, In August 2012 when the SEC adopted final rules on disclosures with respect to conflict minerals and on disclosures of payments resource extraction issuers make to governments (both mandated by Dodd-Frank), Commissioner Daniel Gallagher stated:

I am not able to support this rule today, because the analysis is incomplete. The costs this rule will impose are clear enough. Its intended benefits, by contrast, are socio-political and aspirational in nature, worthy but indeterminate — although they are presumed to justify all costs. And certain key discretionary choices made by the Commission’s rule will have the effect of increasing the rule’s burdens….we have no reason to think the SEC will succeed in achieving complex social and foreign policy objectives as to which the policymaking entities that do have relevant expertise have, to date, largely failed.

This statement (invoking as it does the FRRA emphasis on quantified costs and benefits) does suggest a larger issue, that the regulatory process is being used to second-guess and undermine Congressional mandates. Kraus and Raso point out that the proxy access rule invalidated in the Business Roundtable decision “had been expressly and contemporaneously authorized by Congress.” They ask whether the real explanation for the Business Roundtable decision is that the Court of Appeals did not think that the courts’ deference to agency expertise in scientific areas such as toxicology should extend to expertise in financial economics. If this is so, then the SEC’s implementation of the authors’ recommendation that it insist on its expertise in financial economics will be unavailing. At the same time, the more seriously the SEC addresses cost-benefit analysis as a component of rule-making, the more problematic the courts’ rejections of SEC rule-making will become.


Rosenkrantz and Guildenstern Write Contracts

Mark Weidemaier, Robert Scott, & Mitu Gulati, Origin Myths, Contracts, and the Hunt for Pari Passu, L. & Soc. Inquiry (forthcoming 2012) available at SSRN.

Every so often, an odd take on an obscure thing resonates in a big way. My first clue came when a colleague who writes about cyberlaw blasted around a paper about a silly old clause in government bonds to the entire business law listserv. Then plaintiffs, defendants, and amici on all sides cited to the same paper in briefs to the Second Circuit. Then a big-time finance journalist talked it up over dim sum. Then a bankruptcy friend said that I should review it on Jotwell. To be sure, I knew and liked the piece (and the authors1)  but what was in it for the general audience? It is about a clause with a Latin name and unknown meaning, collecting dust in contracts too-exotic for textbooks. The authors’ major finding is that fancy corporate lawyers who draft the clause like to describe themselves as bits of debris bobbing on the waves of history … even as they paddle while no one is looking. And yet, in their seemingly discrete tale about a technicality, Mark Weidemaier and colleagues strike some important chords.

Weidemaier, Scott, and Gulati write about the pari passu clause in sovereign debt contracts. The clause usually says, with minor permutations, that the debt is and will rank pari passu (in equal step) with others like it. For all anyone knew, pari passu lived a quiet life in bond boilerplate until an enterprising creditor used it ambush a Brussels magistrate, get an injunction, and collect money from an immune government.2  This caused a kerfuffle in both law and policy circles for upsetting the delicate balance between debt collection and sovereign immunity. To the policy people’s credit, they fixed the narrow problem right away with a statute barring similar injunctions in Belgium. But the contract clause remained and even grew in stature, all the while eminent lawyers in New York and London heaped scorn on pari passu and the Brussels court.

The authors do not revisit the literature on the meaning of pari passu, which has convinced me that its contemporary meaning is indeterminate or trivial. Instead, they interview hundreds of lawyers and read hundreds of contracts to figure out why no one has bothered to fix the term, even as nearly everyone professed to be upset about it. Instead of a reason, they get stories of the mythical origins of pari passu, each with some basis in truth, but none that holds up against the facts. The unifying moral of the lawyers’ stories is that pari passu’s birth—be it in early 20th century invasions, or late 20th century banking crises—irrevocably tainted its life, and emasculated its would-be saviors at New York and London law firms. Worse, when Weidemaier and colleagues uncover a pretty convincing version of the truth, the story-tellers do not want to know.

So why should the rest of us care about pari passu or tales of law firm impotence?

  • First, the article comes out at a time when pari passu is again important on the merits. The same creditors that befuddled Belgian courts in 2000 revived the argument in New York, and have now taken it to the Second Circuit. Depending on what the judges say about the meaning of the term, long-uncollectable government debt could become collectable, potentially altering the ways in which governments manage crises. The article puts a damper on both sides’ strong readings of the clause, and (to me) screams out against hanging big policy decisions on language that no drafter can explain or wants to own. Of course if the courts want to make it up, they can and they will.
  • Second, the study offers a provocative take on business contracting. It uses insights from economics, sociology, history and political science to document a rational quest for “completion” that is mired in egos, politics, culture, and institutional frictions. Transaction cost engineers marry Mad Men. But what is to be done? Are the clients ill-served? Should they demand and pay for more original, and more accessible contracts? Is the litigation risk unavoidable (at least at a reasonable cost)? Should courts penalize drafters for writing contracts that are both meaningless and useful (no mean feat, by the way)? On all these questions, the article is mum—more existential sociology than pragmatic law review.
  • Third, the article is methodologically lovely: a mix of archival research, original data mining and number crunching, and in-person interviews. It feels serious but also accessible and unpretentious, melding Weidemaier’s earlier forays into sovereign debt (here and here) and the latest from Scott and Gulati (here). Its theoretical and methodological catholicism makes the piece intuitively credible, and serves as a nice reminder of the empirical potential in law scholarship.

In the end, we are left wondering about the lawyers— craving center stage but stuck in the shadows, with their slightly sad efforts to massage their place in history, smarter than they let on, not smart enough to outwit fate, doomed in the end to lose control over the precious words that were never theirs to begin with. They were sent for. We know how the play ends, but we keep watching. And the quest for pari passu continues.

  1. I have co-authored with Mitu Gulati. []
  2. Holdout creditors argued that the pari passu clause entitles them to pro-rata payment of amounts due. In this reading, creditors that agreed to restructure their bonds at 30 cents on the dollar would not get paid unless holdout creditors that did not agree to debt reduction got 100 cents on the dollar. Debtors have argued that pari passu is a promise of equal ranking, not equal payment. Equal ranking has limited or no significance in sovereign debt, where there is no bankruptcy and no estate to distribute among creditor classes. []

Going Public before the IPO

Darian M. Ibrahim, The New Exit in Venture Capital, 65 Vand. L. Rev. 1 (2012).

For some employees and investors, Facebook did not make the decision to pursue an initial public offering (IPO) fast enough. So when a former employee of Facebook needed to sell some shares in the company, he approached SecondMarket, which describes itself as “the leading marketplace for alternative investments.” In 2009 Facebook shares began trading on SecondMarket and SharesPost, another leading market for shares in companies that are moving toward an IPO. These new markets – called private secondary markets – are the hottest new development in securities trading.

Although we have much to learn about private secondary markets, the first article out of the gates is well worth reading. In The New Exit in Venture Capital, Darian Ibrahim relies on interviews, trade publications, blog posts, and newspaper stories to study these emerging markets. He focuses most of his attention on the so-called “direct market,” which involves the trading of stock in startup companies, as opposed to the trading of interests in investment funds. Ibrahim aims to contribute to the still vibrant literature on venture capital investing, but his description of direct private secondary markets should have a much broader audience.

Traditionally, the venture capital cycle begins with the creation of an investment fund that venture capitalists use to invest in portfolio companies. Venture capitalists typically invest in stages, building a portfolio company from startup to the point where the company can be sold, either through an acquisition by a larger company or through an IPO. Upon the sale of the company or shortly thereafter, venture capitalists extract their investments and any return on those investments, and they distribute much of that money to their fund investors. The cycle then begins afresh with a new fund.

With the decline in IPO activity over the past decade, Ibrahim argues that venture capitalists face a liquidity gap, which could impair the formation of funds at the start of the venture capital cycle. Playing off the debate relating to “capital lock-in,” Ibrahim argues that the dearth of good exit options for venture capitalists creates a form of “investor lock-in,” usually associated with traditional close corporations: “minority shareholders cannot look to the corporation for redemption, and there is no ready market for selling shares to third parties.” (P. 7). Unlike capital lock-in, which may have some beneficial features, Ibrahim argues that investor lock-in is almost all bad for venture capitalists and their portfolio companies, raising the cost of capital and creating governance problems.

Private secondary markets promise some relief from investor lock-in. While most sellers in these markets are entrepreneurs and startup employees, Ibrahim found that venture capitalists were becoming increasingly active as sellers in private secondary markets. The buyers include various investment funds, strategic buyers (other companies looking to gain a foothold toward acquisition), and even some late-stage venture capitalists.

According to Ibrahim, buyers are motivated by a desire to own hot new companies whose shares would otherwise be inaccessible. Also, the companies whose shares trade in direct private secondary markets are “well-known, later-stage companies.” So, investors find the evaluation of these companies easier than the evaluation of early-stage startups. Buyers may also be motivated by the prospect of relatively quick exits: “As long as traditional exits for winning companies are simply delayed, rather than gone altogether, direct market buyers will reap their spoils.” (P. 20).

This last point raises a troublesome question for Ibrahim’s thesis: do these markets work without IPOs? Ibrahim cited three companies as examples of the companies whose shares are sold in direct private secondary markets: Facebook, LinkedIn, and Tesla Motors. All three of these companies subsequently executed IPOs. Indeed, SharesPost claims to be “changing the way companies, investors and shareholders … transact in the pre-IPO economy.”

Thus, it appears that direct private secondary markets observe a fundamental law of investing which I discussed in my paper, The Exit Structure of Venture Capital: “Before [people] invest, they plan for exit.” If direct private secondary markets are designed to fill the liquidity gap created by the dearth of IPOs, as Ibrahim suggests, it is not clear that these new markets will be up to the task. Ultimately, it seems, we need a vibrant market for IPOs if the venture capital cycle is to operate effectively.

The future of direct private secondary markets is uncertain, but Congress attempted to encourage the development of those markets with the recent passage of the Jumpstart Our Business Startups (JOBS) Act. Among other things, the JOBS Act facilitates “crowdfunding” by allowing early-stage companies to raise up to $1 million through small investments from non-accredited investors. The JOBS Act also broadens the appeal of offerings under Regulation D, which may not only encourage more primary offerings, but also more secondary sales.

Private secondary markets have become an important new component in the system for financing innovative companies. Ibrahim’s paper is an excellent introduction to these new markets, and an important contribution to the field of law and entrepreneurship. Brian Broughman organized an excellent panel of papers on private secondary markets at the recent Annual Meeting of the Law & Society Association, and interested readers should look to those papers for the latest new developments in this literature.