Luca Enriques, Alessandro Romano & Thom Wetzer, Network-Sensitive Financial Regulation
, 45 J. Corp. L.
__ (forthcoming, 2020), available at SSRN
It is difficult to know what wisdom from pre-pandemic times will carry forward. One thing that feels very relevant, however, is the notion of applying network-sensitive approaches to regulatory structures that previously were atomistic in orientation. COVID-19 (the global emergency, not the virus) is nothing if not the product of global networks.
It takes some time for the full impact of a new paradigm to be realized. Those of us who have followed the systemic risk literature over the last decade or more will, I think, recognize in “Network-Sensitive Financial Regulation” a more comprehensive embrace of network theory than we have seen so far. Post-crisis recognition of systemically important financial institutions, or SIFIs, has always been somewhat awkwardly bolted onto existing regulatory structures. This is an exceptional article, because it represents a genuine step change in our thinking. It convincingly demonstrates how we might better incorporate network awareness into systemic risk analysis and macroprudential regulation, and then extends its insights further, to the micro level of corporate governance.
Our understanding of how networks operate in financial systems is relatively new. In modelling the financial crisis that started in 2007/2008, we learned a great deal about how risk was transmitted from one institution to another, and how in some cases it ramified into full-fledged systemic risk. With the benefit of hindsight we also recognized the moral hazard that had flowed from certain financial institutions being too big, or too interconnected, to fail: they had to be bailed out for the sake of systemic stability, but that meant that directors, officers, and shareholders of TBTF/TICTF firms were relatively immune to the downsides of the firm’s excessive risk-taking.
“Network Sensitive Financial Regulation” is a mature and compellingly-argued outgrowth of those experiences. Luca Enriques’, Alessandro Romano’s, and Thom Wetzer’s key argument is that “the transition to a regulatory regime that can effectively mitigate systemic risk in the modern highly connected economy will not be complete until financial regulation fully accounts for the structure of the financial network and the interconnections between its components” (P. 4.) Moreover, because of the torque that a firm’s systemic significance can have on normal corporate governance assumptions, network theory also has a contribution to make in the governance domain.
The authors provide a brief and useful history of how financial regulation progressed from the atomistic microprudential concerns of the pre-crisis era, which generated collective action problems and procyclicality, to the macroprudential concerns that governed especially SIFI regulation post-crisis. This much is familiar. From there, in a fresh move, the authors point out that a good deal of post-crisis macroprudential regulation – such as SIFI designations based on a financial institution’s asset size, whether $50bn or $250bn – still operates in a basically atomistic way. (It makes matters worse if regulation is based on binary SIFI/non-SIFI thresholds and bright lines, rather than institution-specific risk assessments.) Sometimes, the atomism is a function of how regulations are written. At other times, potentially network-sensitive methods nevertheless end up being operationalized atomistically.
Consider, for example, interconnectedness. Enriques et al. describe the fundamental concepts underlying network theory, such as nodes and centrality. In crude terms, the more central a financial institution is to a network, the greater its capacity to cause systemic harm. The authors also describe the ways in which different network typologies – mainly, more highly interconnected or looser ones – respond to larger and smaller shocks in different ways. By factoring in data about a firm’s centrality and the typology of the network it operates within, regulators could be in a position to calibrate, more directly, firms’ regulatory obligations to the systemic risk they present.
Instead, firm interconnectedness is commonly evaluated based only on the sum of a firm’s relevant exposures, as if those exposures had the same consequences regardless of the firm’s location within a network, or the network’s characteristics. Activity-based SIFI designations for non-banks, while an improvement on entity-based size thresholds, would also seem to fall into this category. These kinds of suboptimal implementation highlight the degree to which, even post-crisis, we have still not fully taken on board the value of network-level analysis.
One of the authors’ most provocative claims, however, is that just as macroprudential regulation can be made more effective through network-sensitive adaptations, so too can microprudential regulation – that is, corporate governance. Enriques et al. reject the idea that corporate governance rules, including the shareholder primacy norm, are atomistic by definition. When it comes to SIFIs in particular, corporate governance rules incentivize greater risk-taking, and growing the firm to become too big to fail (thereby enjoying a lower cost of financing and externalizing downside risks). In other words, the fact that a firm is systemically significant alters the incentives that would otherwise operate. This is, again, why the firm’s position within a network, and the network’s typology, matter. The authors illustrate this point by demonstrating how other new and interesting proposals around SIFI corporate governance – John Armour and Robert Gordon’s on directors’ and officers’ personal liability, Lucian Bebchuk and Holger Spamann’s on executive compensation, and Yair Listokin and Inho Mun’s on shareholder rights in shadow resolutions – can all be made more context-sensitive, more finely calibrated, and more effective by introducing meaningful network-level data about the firm’s position.
“Network-Sensitive Financial Regulation” reflects an important shift in the unit of analysis, from individual firm to network. It is because the authors have fully absorbed the importance of networks in financial systems that they are able to then roll those insights back to the governance context.
Networks may in fact be the concern of our age. Like internet hive mind rumors, like the pandemic, systemic risk indicators bring home how profoundly the health of our institutions depend on understanding the relationships between them. We were never islands, but nor have we ever been so interconnected. The time is ripe for the kind of paradigm shift that Enriques et al. propose here, in the context of financial regulation and corporate governance.
Editor’s Note: Christie Ford has asked us to to note that this jot was written and edited before the George Floyd and Black Lives Matter protests.
Cite as: Cristie Ford, We’re All in This Together
(June 30, 2020) (reviewing Luca Enriques, Alessandro Romano & Thom Wetzer, Network-Sensitive Financial Regulation
, 45 J. Corp. L.
__ (forthcoming, 2020), available at SSRN), https://corp.jotwell.com/were-all-in-this-together/
Tom Baker, Uncertainty > Risk: Lessons for Legal Thought from the Insurance Runoff Market
, 61 B.C. L. Rev.
__ (forthcoming 2020), available at SSRN
The received wisdom is that insurance can function well in a world of “risk” – the determinable probability of loss — but that insurance can function only poorly, or not at all, in the face of “uncertainty” – the indeterminate probability of loss. This received wisdom colors a lot of thinking, and judicial decision-making, about any number of policy problems, perhaps most prominently about the proper scope of tort liability. If the threat of liability cannot be reduced to a particular probability, the thinking goes, then it will be difficult or impossible to insure against, and part of the point of tort liability, to encourage spreading the risk of loss, will be undermined.
Tom Baker has pioneered the use of qualitative empirical research to shed light on issues in torts, insurance, and insurance law. In this Article, he employs empirical research to call into question the received wisdom regarding the capacity of insurance to function in the face of uncertainty. In an impressive combination of thick description and theoretical insight, he shows how the phenomenon of the insurance “runoff” has been able to function, with increasing frequency and effectiveness, despite the fact that its fundamental purpose is to insure uncertain probabilities of loss.
An insurance “runoff” occurs when an insurer ceases selling insurance and remains in business only to pay claims under previously-sold policies. Baker explains how, in the past several decades, responsibilities for some of the most severe and uncertain insurance exposures, such asbestos and environmental cleanup liabilities, have been transferred by the companies responsible for them in the first instance to runoff entities whose reason for being is to assume these uncertain exposures, for a price. In effect, the runoff entity insures the original company against highly uncertain liability.
In 1996, Lloyds of London created a runoff entity (“Equitas”) to assume its syndicates’ liabilities under past policies, which had long-tail exposure to asbestos, environmental cleanup, toxic tort, and products liability claims. And Warren Buffet’s Berkshire Hathaway owns a runoff company (NICO) that has engaged in Loss Portfolio Transfer (LPT) deals with insurance companies to function in a runoff fashion to liquidate liabilities under these portfolios. Apparently neither Lloyds nor Buffet has read the economics textbooks telling them that this won’t work.
But it has. Not only for Lloyds and Buffet, but also in life insurance, financial guarantee insurance, pensions and annuities, and long-term care insurance. Based on a series of field interviews and other research, Baker walks the reader through the mechanics of runoffs, explaining how a runoff entity engages in the underwriting, investment projection, and insurance policy claims management necessary to insure the uncertain exposure that it has assumed. This is legal sociology at its best, undercovering the actual economics of the runoff entity from the inside. It is impossible to read Baker’s account without being impressed, and maybe a bit frightened as well, by the way that the possibility of making a profit generated the ingenuity necessary to create the very institution of the runoff.
Baker ends by briefly assessing the public policy costs and benefits of runoffs, and comes out provisionally in their favor, all things considered. He argues that insurance is always dealing with one form of uncertainty or another, and that we should therefore jettison the ideal type of insurance as a risk-spreading entity, and substitute a paradigm of insurance as an uncertainty-management mechanism. Perhaps it would be better just to hold these two inconsistent ideas in our heads at the same time. Be that as it may, Baker has helped to shatter the received wisdom about the former idea, and brought the latter idea into the mainstream.
Cite as: Kenneth S. Abraham, Taking A Lesson From Uncertainty
(June 2, 2020) (reviewing Tom Baker, Uncertainty > Risk: Lessons for Legal Thought from the Insurance Runoff Market
, 61 B.C. L. Rev.
__ (forthcoming 2020), available at SSRN), https://corp.jotwell.com/taking-a-lesson-from-uncertainty/
The shareholder base of modern U.S. public companies is diverse. At one end of the spectrum are large asset managers like BlackRock, which by itself has almost $7 trillion in assets under management. At the far other end are ordinary people—so-called “retail” investors. And between these two ends lie a hodgepodge of institutions, including public pension funds, hedge funds, insurance companies, and university endowments. Should corporate law assume that these shareholders all share a common goal?
According to Professor Ann Lipton’s timely and clear-eyed article, Shareholder Divorce Court, the answer is an emphatic “no.” While corporate law has traditionally elided the messy reality of shareholder heterogeneity by assuming that all types of shareholders have the same interest—wealth maximization—the landscape has changed. But as courts in recent years have adjusted and accommodated shareholder preferences that deviate from wealth maximization, they have created a new problem: smaller, less diversified shareholders may now be forced to accept suboptimal transactions that are not designed to promote their interests. Lipton’s account is important. In making her case and exploring how the right of appraisal can be reconfigured to act as a remedy, Lipton excavates yet another consequence of Delaware’s newfound confidence in the efficacy of the shareholder franchise.
As Lipton explains, corporate law traditionally “papered over” the problem of divergent shareholder preferences by entrusting directors, not shareholders, with most corporate decision-making and deferring to directors’ judgments. Nevertheless, under circumstances when the heterogeneous interests of shareholders were too blatant to ignore, courts stepped in to enforce the fiction that shareholders have a uniform preference for wealth maximization. For example, in vote-buying cases, courts have said that a bought vote becomes illegitimate when it does not “reflect rational, economic self-interest arguably common to all shareholders.”
The rise of large, sophisticated, and diversified institutional investors changed things. First, in Lipton’s telling, the “growth of institutional ownership has led to increasing—and increasingly visible—conflicts” between investors’ preferences. Institutional investors are now frequently invested in companies on both sides of a transaction, own both stock and debt in the same company, hold derivatives, and so forth—all of which give rise to idiosyncratic interests that are not shared by less diversified or retail shareholders.
Second, “[i]nstitutional investors’ size and sophistication puts significant strain on the doctrinal axiom that shareholders are too inexpert, or do not have sufficient incentives, to meaningfully contribute to corporate governance,” which had been the original justification for restricting shareholders’ power within the corporation. Recognizing this, the law evolved. Through cases like Kahn v. M&F Worldwide and Corwin v. KKR Financial Holdings, corporate doctrine has “shifted away from judicial enforcement of a fictionalized wealth-maximization norm, and toward accommodation of actual shareholder preferences.”
By connecting these two developments, Lipton deftly leads us to the problem she has identified. The law has moved toward allowing shareholders as a group to choose their own objectives—to choose to depart from maximizing wealth—but it continues to treat shareholders as a monolith, ignoring shareholder conflicts and the reality that certain types of shareholders are systematically more powerful than others. As it stands, the largest institutional investors may use their voting power to induce deals that advance their private interests at the expense of the interests of the corporation or its other shareholders. Smaller shareholders “whose interests do not align with those of the largest institutions” are now “left without an advocate,” and therefore may be “trapped in suboptimal transactions.”
This insight alone is a valuable contribution to the corporate law scholarship. But Lipton does not stop there—she concludes with an elegant solution to the problem using the right of appraisal. According to Lipton, past versions of appraisal had been used to manage shareholder heterogeneity, and appraisal today can be modified to serve its original purpose. Appraisal permits shareholders who dissent from certain actions to receive the appraised fair value of their shares. Lipton argues that a reformed appraisal can be a mechanism to ensure that institutional shareholders will, “in effect, pay other shareholders for the privilege” of inducing the corporation to pursue opportunities that sacrifice wealth maximization in favor of advancing idiosyncratic benefits. Appraisal, in other words, can allow shareholders to effectuate an amicable “divorce.”
Lipton’s works are often prescient, and this article is no exception. As she points out in the very first sentence, “Corporate law is designed to address conflicts of interests among stockholders and managers.” But a different type of conflict—inter-shareholder conflicts of interest—is now too obvious to ignore, so the law must adjust. Lipton’s article does an excellent job of launching this conversation.
Yuval Feldman, Adi Libson and Gideon Parchomovsky, Corporate Law for Good People
, 115 Nw. U. L. Rev.
(2020), available at SSRN.
Corporate law has incorporated some of the sociology of organizations. Often, this is by incorporating the concept of an organization having a culture. The organization’s culture organizes thought by individuals within the organization both by incorporating norms of satisficing and stimulating groupthink. In compliance, “tone at the top” is thought to be necessary. And, the concept of the organization shaping decisions within it explains why pervasiveness replaces mens rea for corporate criminal liability.
For many, organizational sociology is too vague. After all, in 1949, Clyde Kluckhohn demonstrated 73 different meanings that are attached to the concept of “culture.” Although the effects of organizations are apparent, the mechanisms by which organized experience frames individual decision-making are more difficult to understand. This is especially true in a culture, like ours, that prizes the self-determination of individuals.
Enter Corporate Law for Good People by Yuval Feldman, Adi Libson and Gideon Parchomovsky. Committed to methodological individualism, this essay explores individual behavior that is other-regarding and applies this psychology to corporate law. One of the pleasures of this article is its relentless adoption of one species of psychological analysis. It replaces the economically-rational individual with one whose self-interest incorporates a concern for others. The other genius of this article is its unflinching incorporation into corporate law of the results of this perspective.
For example, the authors suggest that board decision-making ought to adopt a “two-tier structure.” First, a single board member ought to make a decision about an issue. Not knowing how others would react, the single board member would be more free to consider the issue in all its complexity. The entire board would be presented with the single board member’s recommendation, but having a decision already made would lessen “the dishonesty that group deliberation generates” and potentially create dissonance with the norms of the board as a whole, thereby improving corporate decision-making. For the same reason, they criticize Van Gorkum’s reliance on lengthy deliberations in itself as a solution to problems of bias.
Psychology is brought to bear to answer the question: Why do people commit wrongs for the corporation even if it hurts themselves? The answer lies in understanding why people do things for their team that they wouldn’t do for themselves. To do that, the authors explore research that they label the field of “behavioral ethics,” although it actually is a subset of writing about the genesis of ethical (and non-ethical) behavior. The key finding of the research that they review is “that transgressions are easier to justify when they benefit other parties.” For example, a lawyer will act on behalf of her client in ways that they might deplore in others.
The article illuminates what has been forgotten in the Caremark line of cases. Chancellor Allen began with the question of board liability for “unconsidered inaction” and the Delaware Supreme Court ended with a rule of liability for failing to respond to red flags flying. In contrast to the Court, the article explores the “‘automatic’ mechanisms” that lead to unconsidered and unethical omissions.
The article then turns to consider situations in which the corporate actor wants “to be sensitive to the interests of others, and, in many cases, actually act according to those principles.” In these situations, sanctioning misconduct, without precisely defining what constitutes misconduct ex ante, will not deter because the actor has the conscious belief that they are in the right. Increasing vagueness in what is in others’ interest, such as replacing shareholder primacy with a stakeholder account, will only increase wrongdoing because it allows “agents more interpretive leeway that may be used to further their own self-interest,” although they consciously are pursuing the others’ interests.
Paying attention to the disjunction between conscious and less than conscious reasoning leads the authors to recast the understanding of “independence” in the context of board members and other professionals. Understanding oneself as “independent,” the authors conclude from psychological studies, “does not provide immunity against wrongdoing, but… may even entice wrongdoing by encouraging the agent to believe that she is immune from the influence of subtle conflict-of-interest[s].”
The authors justify imposing liability on the corporation for the actions of its agents because the agents are justifying their misconduct on the grounds that it is in the interests of the corporation. This is true even when the wrong-doing also personally benefits the wrong-doer because “there is a greater tendency to promote one’s self-interest when it also benefits others.”
On point after point, the authors have us reframe what we thought we knew about corporate behavior. They prove again and again what Louis Auchincloss knew when he told us that friendship in corporate life is often a way to later get the “friend” to do the unethical. But the authors take this insight into reconceiving corporate law.
As lawyers we know that we become vulnerable by taking on clients: We may forget our ethics in advancing client interests. The authors, however, emphasize that in asserting that our decisions are dominated by our clients, we also can hide to ourselves how we are pursuing our self-interests, such as running up the bill in order to better serve the client. We think of ourselves as “good people” but are being biased in ways that may serve ourselves more than our clients.
Although the article is full of insights, there is a cost in reducing sociological phenomena to individual ones. They praise requiring managers to certify that they didn’t manage earnings because it reframes “a passive behavior into an active one.” Perhaps, but many corporate cultures transform that certification into being understood only as “I trust my subordinates.”
There also is a cost in taking literature on bias in decision-making on behalf of others as constituting the field of “behavioral ethics.” First, even if we reduce ethics to “other-regarding actions,” that we can criticize these actions reveals that we have not subsumed ethics to these behaviors. Second, psychology has produced much more than an account of biases (and diseases). For example, positive psychology is not in evidence in this article. While professionals can hide to themselves how their supposed independence is working at the expense of their clients, professionalism also may augment dignity, bravery and persistence, habits of the heart that can stimulate ethical activity. Of course, these criticisms are beyond the scope of this article, so they do not lessen its own charm.
Sarath Sanga, On the Origins of the Market for Corporate Law
, available at SSRN.
Professor Sarath Sanga’s paper titled On the Origins of the Market of the Corporate Law is a thought provoking challenge to popular beliefs concerning the origins of the market for corporate law and state charter competition, that is: (1) Supreme Court jurisprudence helped create a national market for corporate charters; and (2) Delaware became a market leader only because New Jersey (the initial leader) repealed its liberal corporate laws in 1913.
Instead, the paper contends that these two popular claims are wrong. It offers an alternative explanation: organic industrial expansion and interstate commerce led to the emergence of the market for corporate law and that New Jersey declined as a market leader due, in part, to other states copying its laws.
Paper’s Central Findings
The paper contains an explanation of its methodology and data collection, so I will not focus on it here. (Pp. 12-17.) Instead, I will focus on the paper’s findings and the implications for scholars, firms, and policymakers. The first central claim is that Supreme Court jurisprudence, particularly the often-cited holding from Paul v. Virginia, did not set in motion the path to a national market for corporate law. Instead, the paper argues that Paul v. Virginia is “one in a long line of cases that opposed a national market and empowered states to discriminate against foreign corporations.” (Pp. 11-12.) Relying on historical sources and Supreme Court jurisprudence, the paper asserts that the Supreme Court did not promote a national market for corporate law. Instead, the Supreme Court throughout the 19th century and into the 20th century, regularly affirmed the states’ ability to discriminate against corporations with out-of-state, i.e., foreign charters. (P. 4.)
The second traditional claim the paper challenges is that New Jersey’s “Seven Sisters” regulation, repealing its liberal holding company statute in 1913, led to massive corporate migration, particularly to nearby Delaware. The paper relies on empirical evidence to show that New Jersey’s decline as the premier site of incorporation began shortly after 1903, nearly a decade before the “Seven Sisters” legislation and nearly seven years before Woodrow Wilson campaigned for governor in 1910. (P. 16.)
By the late 19th century, according to the paper, “the market for corporate charters was an accomplished fact.” (P. 18.) It contends that New Jersey’s liberal corporate statute, which long predated 1913, catalyzed greater migration to New Jersey by attracting foreign firms with “little or no connection to New Jersey.” (P. 19.) In essence, New Jersey’s early emergence as a leader in corporate charters is evidence of a somewhat competitive market for corporate law.
But if neither the 1913 Seven Sisters legislation nor Woodrow Wilson’s campaign for governor led to New Jersey’s decline, then what explains New Jersey’s earlier decline in the charter market? The paper maintains that basic competition from other states, copying New Jersey’s liberal pre-1913 corporate statute, explains New Jersey’s decline.
Paper’s Contribution to the Existing Body of Literature
Alternative Historical Account of New Jersey’s Decline
The paper supports an earlier timetable for the creation of a corporate law market and New Jersey’s decline as a premier site of incorporation. It maintains that the primary force behind the corporate law market was not necessarily a function of Supreme Court jurisprudence. Instead, it was a more organic process influenced by financial returns generated by firm expansion and multi-state operation. (P. 5.) Moreover, New Jersey’s preeminence was significantly undermined by jurisdictional competition and not solely due to the 1913 legislative changes.
Delaware’s Dominance and the Nature of Competitive Advantage
Although the paper deals primarily with New Jersey’s emergence and decline in the corporate chartering market, what does this narrative say about Delaware’s emergence and longstanding dominance? It suggests how a jurisdiction’s points of parity, such as statutory innovations that are easily replicated by other states, will not necessarily lead to sustained dominance. We should instead look to a jurisdiction’s points of differentiation, that is, its unique advantages, to account for sustained dominance in the charter market. Indirectly, the paper’s findings reinforce the body of literature suggesting some other factors besides law may account for Delaware’s sustained dominance in the corporate charter market, e.g., its court system, its brand, the preferences of corporate lawyers, and franchise taxes.
Paper’s Implications for Scholarly Debate and Future Research
Historical Trends Provide Valuable Context to Modern Debates
Whereas the paper addresses Supreme Court jurisprudence and New Jersey legislative developments at the turn of the 19th century, it simply acknowledges, but does not discuss, concomitant developments in other states like Delaware. According to some commentators, the provisions of Article IX of the 1897 Delaware State Constitution “radically changed the complexion of Delaware incorporation law and helped to propel Delaware to the position of corporate law pre-eminence that it occupies today.” Specifically, these state constitutional provisions abolished incorporation by special act and created a general incorporation act that had significant influence. Prior to this time, incorporations occurred primarily through special acts of the Delaware legislature and the average wait time was two years. Opponents of the special act procedure feared it inspired corporate “lobbyists” to exercise undue influence over Delaware politicians. As a consequence, Delaware established a general incorporation procedure as the exclusive method of incorporation for all Delaware entities (except for banks). Two years later, in 1899, Delaware adopted a comprehensive general incorporation law that, similar to other states, replicated aspects of New Jersey’s liberal corporate statute. Complementing a liberal corporate statute, Delaware adopted a franchise tax structure significantly more favorable than New Jersey’s. This parallel Delaware historical narrative complements the paper and its data by suggesting that Delaware’s ascendancy began earlier than New Jersey’s repeal of its liberal corporate statute in 2013. (Pp. 29-33.)
Modeling Incorporation Decisions
Incorporation decisions are not likely driven by a single variable. Perhaps it makes sense to view incorporation decisions akin to the purchase of a bundled product. Such an approach accommodates multiple contributing factors (e.g., regulatory environment, courts, and taxes) and may reconcile seemingly competing claims. From this vantagepoint, the interstate competition and firm expansion claim is consistent with New Jersey eventually being perceived as less competitive or in parity with other states, and Delaware emerging and sustaining its dominance through differentiation advantages.
In conclusion, Sanga’s paper is an insightful read for scholars interested in the origins of state charter competition and potentially its future.
Marc T. Moore, Designing Dual Class Sunsets: The Case for a Transfer-Centered Approach
, University College London Faculty of Laws Working Paper No. 9/2019, available at SSRN
The optimal balance of power between shareholders and boards of directors in public companies remains one of the most consequential and contested issues in corporate governance, and the debate has only intensified as share ownership has become more concentrated in the United States and U.S.-style shareholder activism has arisen in other capital markets around the world. Against this backdrop, as Marc Moore explores in the paper cited above, dual class stock (DCS) structures “have spread exponentially in recent years across much of America’s public company community,” and “certain jurisdictions that have traditionally been averse to permitting DCSs have come to recognize the potential benefits of taking a more permissive stance” – including Singapore and Hong Kong, two of the world’s most prominent financial centers. In his paper, Moore maps this complex terrain, providing a comparative analysis of various approaches to regulating DCS structures and calibrating associated incentives. Specifically, he focuses on “whether DCSs should be perpetual or rather should terminate (or ‘sunset’) at some point in time,” and “the most appropriate means of determining when and how time-limited DCSs should sunset.”
Moore observes that U.S. tolerance for DCS structures and associated deviation from the one share/one vote approach “would appear to be more international outlier rather than norm,” even relative to the United Kingdom where “London’s traditional capital market norms have proved considerably less tolerant in this regard.” Through a detailed discussion of extant literature, he contrasts proponents’ aim to give management “a degree of strategic breathing space … from the intense pressure exerted by quarterly financial reporting hurdles” with opponents’ concerns regarding various forms of controller agency costs borne by holders of low-voting stock.
Singapore and Hong Kong, however, have pursued intermediate approaches that point toward a spectrum of possibilities in DCS design. Both have recently liberalized their listing rules to permit DCS structures under certain circumstances as a means of attracting innovative high-tech companies, but only within specific regulatory parameters, which include sunsets. Notably, in both jurisdictions, multiple-vote shares generally convert to single-vote shares upon transfer. Meanwhile, alternative sunset models have been advocated, including ownership-based sunsets, under which conversion is generally triggered by multi-vote shareholders’ cash-flow interest in the company falling below a specified level (say, 10 percent), and time-based sunsets, under which conversion is generally triggered by passage of a specified period of time (say, 10 years). As Moore describes, the latter have increasingly been adopted, on a firm-by-firm basis, in the United States.
Acknowledging that “there are in practice a variety of general sunset models for investors, managers and (where relevant) regulators to choose from” along the foregoing lines, and “a wide range of specific potential triggers within each of those models” that might be adopted, Moore concludes that transfer-based models generally ought to be favored. Notably, Moore argues that “regulatory requirements for fixed-term sunsets calibrated on anything wider than a firm-specific basis are inherently arbitrary,” and that even firm-specific sunsets of this sort may prove undesirable because, “by their very nature, they are designed proactively a number of years ahead of their intended activation.” Ownership-based thresholds, requiring that a certain level of economic interest be maintained, may prove “less problematic” in this regard, yet are still “susceptible to the same charge of eliciting crude and factually insensitive outcomes” in so far as a founder or other controller may have “legitimate prudential motivations for wishing to liquidate part of her multi-vote holding.” Having to forego such flexibility might “increase the relevant firm’s cost of raising fresh equity capital from prospective future controllers.”
The transfer-based approach adopted by Singapore and Hong Kong, on the other hand, generally “will only be triggered by the death or retirement (as a director) of the multi-vote holder(s), or the sale of her equity stake,” which “insures against the risk of disturbance to the firm’s pre-existing business trajectory.” By the same token, Moore observes that since a transfer of control “entails a sudden change of trajectory for the firm’s business (whether strategically or at least culturally) in any event, it follows that conversion of the firm’s capital structure at this point in time will not in itself be a likely cause of organizational destabilization.” Based on these and other considerations, Moore suggests that U.S. regulatory authorities “give serious consideration to adopting the transfer-centered model of sunset regulation that has recently been implemented by the Hong Kong and Singaporean exchanges, as a more moderate alternative” to the time-based approach that institutional investors have advocated.
Moore’s comparative framework brings analytic clarity to a rapidly evolving set of corporate governance issues, while raising important normative and empirical questions for future research. For example, given the general arguments against DCS structures, perhaps there is a reasonable normative case to make for U.S. adoption of a moderate brake on their use, as Moore’s analysis suggests. Conversely, however, given the general arguments in favor of DCS structures, perhaps there is likewise a reasonable normative case to make for moderate liberalization of the U.K. approach, departing from London’s historically “less tolerant” position in the other direction. By the same token, the intermediate approaches recently adopted by Singapore and Hong Kong may or may not, as an empirical matter, strike the stable balance desired. Should they prove unworkable, or otherwise be disfavored by an increasingly globalized marketplace, this might re-focus attention on the more extreme approaches, in one direction or the other, or some new approach entirely – time will tell. Regardless, Moore’s framework provides a nuanced and insightful guide to the issues, and a clear lens through which to assess future developments in this dynamic area of corporate governance.
Cite as: Christopher M. Bruner, Dual Class Stock in Comparative Context
(February 12, 2020) (reviewing Marc T. Moore, Designing Dual Class Sunsets: The Case for a Transfer-Centered Approach
, University College London Faculty of Laws Working Paper No. 9/2019, available at SSRN), https://corp.jotwell.com/dual-class-stock-in-comparative-context/
Credit Default Swaps (CDS), like banks, are mind-blowingly simple and potent credit replication machines. Banks replicate their own credit—conjuring gobs of money out of thin air—with a license and a convoluted web of guarantees from the state. CDS can replicate anyone’s credit, with industry-coordinated standard contracts embedded in a tangle of carve-outs, safe harbors, and exemptions from statutes and regulations. The 2007-2009 financial crisis brought a heap of bad press and new regulatory requirements for CDS dealers and trading infrastructure, but did not fundamentally alter the contractual governance paradigm at the heart of this multi-trillion dollar market.
Opportunistic or downright slimy behavior in a space so carefully shielded from substantive regulation can be hard to diagnose, even when it poses an existential threat to the CDS market and could spill beyond it. Recent reports of bad behavior have prompted high-profile lawsuits, contract reforms, and a crop of law review articles revisiting contractual, statutory, and regulatory ecosystems for CDS.
The range of approaches reflects the multifaceted challenge, but can be confusing. Gina-Gail Fletcher’s analysis in Engineered Credit Default Swaps: Innovative or Manipulative? is thoughtful, comprehensive, and a good place to start.
Loaves, Fishes, and Freedom of Contract
Suppose Creditor Cindy Corp. buys $100 million in bonds issued by Borrower Ben, due a year hence, with a $3 million interest payment due in six months. At the other end of the galaxy, Trader Joe—a stranger to Cindy and Ben—bets that Ben is broke. Another stranger, Dealer Dave, takes the opposite side of the bet. He offers to pay Joe $100 million if Ben does not pay Cindy in full and on time, in exchange for a $3 million fee. If Joe accepts, he and Dave would be in a CDS contract on Ben (the “reference entity”), where Joe is a “protection buyer” and Dave a “protection seller.”
If Ben repays Cindy as promised, Dave earns $3 million, just like Cindy. If Ben defaults at the end of the year, Dave loses $100 million, less $3 million, just like Cindy.
The new CDS contract doubles the galaxy’s exposure to Ben’s credit. Absent regulatory constraints, any two counterparties willing to take opposite sides in a bet on Ben’s credit could do the same as many times as they wish. Losses from a Ben default could keep multiplying in distant corners of the galaxy entirely unconnected to Ben or Cindy.
CDS terms need not track Ben’s original debt contract precisely. Joe and Dave might have a contract for six months (through Ben’s interest payment), or for half the notional principal amount. Because CDS isolate and transfer credit risk, the list of “credit events” that may trigger Dave’s obligation to pay Joe differs from the “events of default” in Ben’s contract with Cindy. The CDS would also ignore Cindy’s actual response to Ben’s distress: the bet is on Ben’s condition, not on Cindy’s risk management.
For instance, if Ben’s interest payment is a few days late, Cindy might let it go if she knows Ben is good for the money, but Dave would still have to pay Joe. If Ben hits a rough patch, he and Cindy might amend their contract to postpone the maturity date, avoiding default to Cindy—but not Dave’s obligation to pay Joe. If Ben files for bankruptcy protection, it would stay Cindy’s claim on Ben, but not Joe’s claim on Dave.
Joe and Dave inhabit a parallel Ben-credit universe, simplified and abstracted from Ben’s real-world relationship with Cindy. Ben’s business problems can affect Joe, Dave, and other perfect strangers elsewhere in the galaxy in ways that are neither visible nor manageable under the Ben-Cindy contract.
Trader Joe and Dealer Dave do not write their CDS contract from scratch. ISDA, the derivatives industry association, has produced standard terms for CDS and other derivatives since the 1990s, leaving the parties to customize a limited set of relationship- and transaction-specific items. ISDA also works with governments and lawyers around the world to ensure that its contracts are enforceable everywhere. Robust industry-coordinated standardization often gets credit for derivatives market liquidity.
Keeping regulators at bay remains an important part of ISDA’s work. To succeed, it must foster public faith in the industry’s capacity to regulate itself: preventing and mitigating market disruptions, responding to shocks, and adapting contracts and market practice to new circumstances. To that end, ISDA has taken on new functions over time. It has established an auction procedure to calculate payouts, and a limited adjudication mechanism in the form of industry-staffed regional “Determinations Committees,” which decide whether a CDS credit event has occurred.
The result is a peculiar ecosystem. The same mechanisms that help the industry adapt and respond to shocks also risk transmitting hiccups in any given bilateral relationship or seemingly isolated contract interpretation to distant markets and otherwise-unrelated firms.
Knaves in Loopholes
ISDA’s CDS contract interpretation posture tends to the formal end of the spectrum. In most cases, Determinations Committee decisions have stuck to plain meaning and the four corners of the contract. This approach is at least intuitively consistent with the emphasis on market liquidity: importing relational context in an arm’s length wager could make it hard to trade.
On the flip side, a commitment to narrow textual reading creates arbitrage opportunities, or worse, invites behavior that is patently inconsistent with the spirit of the CDS contract and its market function.
Enter Hovnanian, a home building firm, and GSO Capital Partners, a hedge fund affiliate of the Blackstone Group. In 2017, GSO offered to refinance Hovnanian’s debt on below-market terms, provided Hovnanian borrowed just over $1 million from its own subsidiary and briefly defaulted on an interest payment. The late payment was enough to trigger more than $330 million in CDS that GSO had bought from another hedge fund, Solus, and Goldman Sachs, but not enough to harm the builder’s credit otherwise. Under ISDA’s auction rules, the debt to Hovnanian’s subsidiary also helped inflate the payout to GSO. Solus lobbied ISDA, made a public stink about GSO’s slimy ways (it had pulled a similar trick in 2013), sued, and settled in 2018.
In the end, Hovnanian got cheaper funding and GSO might have made a bundle off another hedge fund. In the words of one prominent commentator, the incident might have threatened the “integrity and viability of the CDS market,” but had no serious “real world” (read real economy) consequences. Who cares?
Fletcher’s article does a lovely job wading through the thicket of pros and cons to answer this question. The cons come out ahead precisely because she takes CDS to be valuable as a source of market liquidity. If CDS contracts detach from the underlying credit risk and become bets on the likelihood of collusion between the reference entity and a CDS counterparty (in the manner of insurance fraud, minus insurance regulation), they lose value for CDS and credit market liquidity, price discovery, and credit access.
The article’s typology of “engineered CDS”—miscreant behavior involving CDS counterparties and the reference entity—covers Hovnanian-style “manufactured” defaults driven by protection buyers, as well as protection seller schemes to kick default just beyond the CDS contract term, or to frustrate the point of a CDS contract by moving all debt from the reference entity to its subsidiary. In all three transaction types, the trouble starts in the CDS parallel universe; smoke may drift into the real world, but the harm is uncertain and would be hard to ascertain empirically.
To the extent these arrangements are harmful, Fletcher’s doctrinal analysis is especially worthwhile for illustrating the breadth and interdependence of contractual, statutory, and regulatory maneuvers shielding CDS contracts from government intervention. Express contract terms and recent court decisions virtually foreclose arguments about good faith, while the SEC and CFTC jurisprudence make it hard to prove manipulation, particularly where the existence of engineered transactions is widely known and baked into CDS prices. This might explain why the SEC and the CFTC have limited themselves to censorious press statements.
Meanwhile, ISDA has tweaked its contracts again, putting more stock in adjudication and Determinations Committees’ judgment. The Determination Committees now have the authority to distinguish between credit events stemming from credit deterioration and those (engineered ones) detached from it.
I share Fletcher’s skepticism of Determination Committees’s capacity to lean into this new authority; I also suspect it is as good as it gets. Instead of investing in ISDA’s already strained adjudication apparatus, I might prefer to revive good faith (the article offers two ways to go about it) and, even less plausibly, a return to public adjudication. Generalist judges might get it wrong sometimes, but the derivatives industry is better equipped than most to compensate for judicial missteps. Shielding it from inexpert scrutiny has not made the public more informed or more sympathetic, and has hardly been good for its own health.
Corporate law has a short historical memory. One result is that conceptual battles that go nowhere get refought, as a look at much of the literature generated in the wake of Citizens United will confirm. There are a few historical classics in the academic literature though. The lead publication in this short stack is Harold Marsh’s Are Directors Trustees? Conflicts of Interest and Corporate Morality, published in The Business Lawyer in 1966. Marsh told a stark story about the decline of the duty of loyalty, which he said went from flat prohibition of self-dealing transactions in 1880 to a general permission subject to judicial fairness review in 1960. Norwood Beveridge challenged Marsh’s description of the early period in a couple of papers published in the 1990s, but the Marsh account has held its place.
Now comes LSE’s (London School of Economics) David Kershaw with a masterful comparative history of corporate fiduciary law in the United States and the United Kingdom, The Foundations of Anglo-American Corporate Fiduciary Law. (The book’s introduction is posted here.) Kershaw seconds Beveridge and dispatches Marsh in a splendid account. The comparison holds the key. Yes, the UK had a prohibition that could be relaxed with a shareholder vote, a prohibition that found its way into the law of a number of US states. But what worked in the UK proved dysfunctional in the US. The conceptual framework of UK corporation law came from partnership, while the US framework came from legislated incorporations. Where the UK had default rules, the US had mandates, with the result that the self-dealing prohibition really was a prohibition here where it was not in the UK. Meanwhile, many states never adopted it and, analogizing to trust law, let officers and directors contract with the company subject to approval by a disinterested director majority.
What in Marsh comes forth as a story of indefensible accommodation of the management interest, in Kershaw is a story of legal doctrine working itself out within its own four corners. Indeed, Kershaw is affirmatively, brazenly positivist and anti-realist. I cannot join him in that. But that doesn’t stop me from thoroughly enjoying his treatment and according him much the better of the argument on this particular point. It turns out that what I thought was a contemporary turn to process review is in fact a reversion to a basic pattern.
Marsh and self-dealing transactions aren’t the only thing on offer here—the law of self-dealing transactions is one of four modules. The others cover the business judgment rule, the duty of care, and the law of corporate opportunities. For each, Kershaw traces back to a start point in UK common law and then brings both systems forward in time. For example, the duty of care comes from bailments. As the doctrinal logic unfolds differently across the two national economies, a compelling story gets told. I particularly benefited from the account of the business judgment rule, as to which my understanding was embarrassingly imperfect. I also greatly benefited from what was for me a needed introduction to UK company law.
Kershaw cares deeply about corporate law as law and manages to communicate his enthusiasm to his reader. Such passion is surprisingly rare in the field, making this book all the more welcome.
Yuval Feldman’s book, The Law of Good People: Challenging States’ Ability to Regulate Human Behavior provides a thought-provoking framework to advance our understanding of how governments should deal with misconduct committed by normative citizens blinded by cognitive biases regarding their own ethicality. While it does not discuss corporate law, this novel framework can offer new insights on fundamental questions of corporate law, securities regulation, and corporate misconduct.
The dominant enforcement paradigm is based on the idea that governments deal with “bad people”—those pursuing their own self-interest—by setting prices or sanctions for misconduct. Feldman, however, draws on the neglected discipline of behavioral ethics to argue that many forms of “ordinary unethicality”—such as workplace discrimination, insurance fraud or tax evasion—are committed by “good people” blinded by self-serving processes such as self-deception, motivated reasoning, ethical dissonance, and moral disengagement. Feldman convincingly shows that the existing analysis of law enforcement misses an important category of good people who may violate legal norms without feeling immoral or thinking that they are indeed in violation of law.
The book pays special attention to subtle conflicts of interest, where many good people may not recognize that there is something wrong or unethical about their behavior. The book explains that a focus on those “good people” will enable regulators to determine in advance which types of situation are likely to encourage acts of ordinary ethicality and develop appropriate regulatory responses. Feldman explores ways to expand the regulatory toolbox in order to allow the government to shape the conduct of good people in an effective manner. Specifically, the book argues that the focus on good people requires a shift in the focus of the legal regime from ex post liability to ex ante design.
Although Feldman does not address corporate law, securities regulation or corporate misconduct, both his thesis and the framework he develops offer important lessons for corporate law scholarship. The book convincingly demonstrates both the complexity of regulating behavior in the corporate setting and the promise of alternatives. Many fundamental corporate law questions arise when “good people” make self-serving decisions, and many cases of corporate misconduct involve corporate executives who made business decisions that turned out to have catastrophic effects. The book’s innovative paradigm uncovers the complexity of using legal rules to improve corporate decision-making processes.
One of the main challenges for corporate law is addressing directors’ conflicts that arise not from pure financial incentives, but from the realities of the modern corporation. Boards of directors need to decide how much to pay the company’s CEO, whether the company should sue other directors for alleged violations of the duty of loyalty or the duty of care, and whether the company should transact with other corporate insiders. Directors’ failure to make optimal decisions under these circumstances is often presented as purely incentive driven. Under this view, directors have self-interested reasons to cater to insiders’ wishes in order to continue serving as directors (and enjoy the income and the networking opportunities). This influential view arguably calls for expanding directors’ liability for breaches of their fiduciary duties.
Feldman’s framework, however, demonstrates that the dynamics of directors’ decision-making may be far more complicated. Behavioral ethics takes the view that people’s actions are based on self-interest in that they serve a need to maintain a positive and coherent view of the self. Thus, the effect that self-interest has may be implicit—by modifying cognitive processes without people’s admitting to themselves that such influence exists—rather than explicit. Under this account, subtle conflicts may lead directors who genuinely believe that they do the right thing to make poor (but self-serving) decisions. Directors are subject to a vague, open-ended standard (fiduciary duties) that requires them do what is best for the corporation and ignore their own self-interest. Directors, however, must make business decisions under conditions of uncertainty about the best course of action for the company.
Consider, for example, independent directors who are asked to decide whether the company should enter into a major transaction with its controlling shareholder. The controlling shareholder has the power to nominate directors and the directors serve at her will. Under these conditions, even when the transaction with the controller reduces value, implicit cognitive processes might lead the directors to believe that the transaction would benefit the company and its minority shareholders. In other words, it may simply be the case that directors use motivated reasoning to make decisions that cater to those they are supposed to monitor—the company’s CEO or its controller. Feldman’s analysis therefore suggests that subjecting directors to more liability won’t be effective in containing poor decisions that arise from structural bias. Rather, corporate law should resort to ex ante measures (for example, change the regime governing director elections) or focus on improving the process for making board decisions.
To summarize, I strongly recommend this fascinating book for corporate law scholars interested in getting a new perspective on how corporate law could more effectively affect the behavior of companies’ officers and directors.
Hillary Sale, Social License and Publicness
(June 13, 2019), available at SSRN
Why can’t Facebook persuade senators to help the company get its new Libra cryptocurrency off the ground? Why is VW running strange apology ads with Simon & Garfunkel’s Sounds of Silence and an allusion to light ahead? Many more questions could follow in this vein and the concept we’ve been looking for is an erosion of “social license.”
Sometimes an article has an idea so sticky that once you read it, you see relevant examples everywhere. You have a better vocabulary to discuss a phenomenon that you have long observed and might otherwise have used many words to describe. Professor Hillary Sale’s new article Social License and Publicness achieves all of this and more.
Most importantly, Sale brings the sociological theory of social license into the business law discourse, enabling a deeper discussion of the dynamic, real-world context in which corporations act. Few corporate law scholars follow the sociology literature and Sale makes a valuable contribution by importing it and offering trenchant legal and business analyses.
As Sale explains, social license refers to the idea that businesses are social institutions that “exist with permission from the communities in which they are located,” as well as from other stakeholders, and are subject to public accountability. Businesses receive social license by developing “legitimacy, credibility, and trust.” In short, operating a business requires both legal license and social license—the former “can be applied and paid for,” but the latter “must be earned with consistent, trustworthy behavior.”
The magic of understanding this concept and giving it salience with a label is that you can then see predictable consequences that arise when a business loses this essential ingredient for sustainable operation. Sale illustrates the loss of social license with two case studies, Wells Fargo and Uber. While other scholars have studied these companies and their scandals, Sale offers a unique perspective that is grounded in her highly influential concept of “publicness.”
She starts the case studies by carefully detailing how the companies originally established their social license. Taking, for example, Wells Fargo, she recounts how it had been one of the top-ranked banks in the U.S. and one of the largest companies in the world. It had, quite amazingly, come out of the financial crisis of 2008 relatively unscathed and with a good reputation. Sale is a great storyteller here, building the narrative tension with positive details and then bit by bit taking the reader through the cultural and organizational problems that allowed for widespread illegal activity to grow at the bank.
Further, she highlights the Los Angeles Times articles that brought the Wells Fargo consumer account scandal to light and sparked public outrage and a series of costly consequences. Her discussion particularly shines in describing the aftermath as the reader can clearly connect the loss of social license with the outcomes of publicness crashing down on the bank. The article collects the wide range of responses that can flow from eroding public trust, including everything from negative publicity, protests, and consumer boycotts, to new regulation, enforcement, and litigation.
Sale’s insights will be enormously helpful to scholars working on issues of compliance, ESG (environmental/social/governance), corporate culture and reputation, human rights, political activity, board oversight, and more. The article has already informed my analysis of the social pushback that can arise as a constraint on regulatory arbitrage and undoubtedly others will also owe Sale an intellectual debt.
Moreover, the article enriches not only academic debate, but also gives corporate directors and executives a valuable tool to implement stakeholder-based corporate governance practices and engage in risk management. Sale provides specific actions that corporate boards can take to avoid losing social license. Notably, with the pre-IPO Uber case study, she also shows that being a private company does not equate to operating under the radar. Startups as well as listed companies should keep an eye on their public responsibilities and their impact on stakeholders.
Finally, the article could not have come at a better time—the CEO of one of the world’s largest institutional shareholders has recently called on corporate leaders to pay attention to the precise issue of social license and to account for the public nature of their actions. Interest in corporate ESG initiatives is at an all-time high. Daily headlines capture Big Tech’s destruction of public trust and the intensifying outcry for a regulatory overhaul. All of the above, from content to timing, makes Social License and Publicness a must-read article.