Corporate governance debates tend to dismiss “Main Street” individual investors as irrelevant. The traditional archetype of the corporation presumes that individual shareholders are apathetic because they own small stakes and confront collective action challenges. In the modern corporate landscape, individual shareholders are overshadowed by their institutional counterparts, who hold near-majority stakes in most public companies. Stories about individual investors tend to highlight their idiosyncratic goals or their distracting irrationality. Think of Charles Pillsbury, who bought a single share of Honeywell in order to campaign to end Honeywell’s munitions production for the Vietnam War. Or the recent meme stock craze, which was widely reported to be driven by “amateur” investors trading on social media hype instead of corporate fundamentals.
But there are important exceptions to this generalization, as Kobi Kastiel and Yaron Nili remind us in their article, The Giant Shadow of Corporate Gadflies. The article brings to the fore the underappreciated role that “corporate gadflies” play in promoting good corporate governance (at least from a shareholder-centric perspective). Kastiel and Nili describe gadflies as “small, ‘pesky’ individual shareholders who are engaged in the submission of massive numbers of shareholder proposals.” There are just a handful of gadflies in existence today, including William and Kenneth Steiner, John Chevedden, the Rossi family, and the husband-and-wife team of James Ritchie and Myra Young.
According to Kastiel and Nili, corporate gadflies function as “governance facilitators”: Gadflies prepare and submit mainstream governance reform proposals—those that proxy advisers and the largest institutional investors have already publicly endorsed—for inclusion on companies’ ballots. As the Article carefully documents, the influence of gadflies has grown steadily over the past fifteen years. Between 2005 and 2018, they accounted for 27.3% of shareholder proposals submitted to S&P 1500 companies, surpassing established institutional actors such as labor unions (21.9%) and public pension funds (15.3%). In fact, just five individuals accounted for 41% of all non-withdrawn shareholder proposals submitted to S&P 1500 companies in 2018.
Governance-related proposals submitted by gadflies have translated into meaningful changes at recipient companies. About a quarter of the proposals submitted by gadflies received a majority of the shareholder vote, which gives gadflies a higher success rate at the ballot box than most of their institutional counterparts. As others have observed, large institutional investors are “rationally reticent.” They publish detailed guidance on the “good” governance practices that they will vote to support. But for a variety of reasons, such as conflicts of interest and fear of attracting regulation, most large asset managers have no appetite for initiating reforms to implement those practices at their portfolio companies. Gadflies have stepped up to bridge this gap.
In fact, gadflies may function within an even broader collaborative ecosystem, in which they, institutional investors, and activist investors play complementary roles to hold corporate managers accountable to shareholders. In this framework, activist investors are the monitors: as Ronald Gilson and Jeffrey Gordon described in earlier work, activists “specialize in monitoring portfolio company strategy and formulating alternatives when appropriate.” The effectiveness of activist investors depends on their ability to credibly threaten to remove the board of directors in a proxy contest, which in turn partly depends on the arsenal of governance tools (such as majority voting, declassified boards, or shareholders’ right to call a special meeting) available to them at the target companies. Gadflies facilitate investor activism by enlarging this toolkit. Kastiel and Nili’s data show that gadflies have submitted more proposals relating to shareholder rights and the removal of proxy battle defenses than any other topic. And institutional investors are in charge of voting: They react to activists’ and gadflies’ interventions that reach the corporate ballot box and decide between competing positions.
Understanding gadflies’ function is particularly relevant today because, as Kastiel and Nili explain with some urgency, gadflies face possible extinction. In September 2020, the Securities and Exchange Commission amended the eligibility requirements for submitting shareholder proposals. This rule change means that the costs corporate gadflies must incur to finance their activities are now higher—perhaps prohibitively so. But rather than simply bemoaning this development, Kastiel and Nili see opportunities as well. There are opportunities for evolution; among other suggestions, they propose the creation of “Gadflies 2.0,” whereby the gadflies’ role could be assumed by a centralized “professional” organization that can handle the submission of shareholder proposals on a larger scale. More importantly, there are opportunities to advance the debate on the role that institutional shareholders should play in corporate governance. For instance, do the conventional arguments that justify large asset managers’ historical reticence to use their power, such as lack of capacity or specialization, translate easily to a purely administrative task like submitting shareholder proposals on reforms that asset managers have already endorsed? And is the current system, in which large institutional investors and proxy advisers determine market-wide governance standards akin to regulation, even structurally desirable?
Kastiel and Nili’s contribution is a valuable complement to the growing body of corporate law scholarship trained on institutional actors. It not only brings attention to the handful of individuals whose outsized influence on U.S. corporate governance has thus far been overlooked, but uses this case study to deftly illuminate the complex and evolving complementarity between different investor types.
Wisdom sometimes is best recognized by a traveler. In Delaware’s Fiduciary Imagination: Going-Privates and Lord Eldon’s Reprise, Professor David Kershaw of the London School of Economics revisits cases that we know very well, putting them in the context of British decisions, and elicits a distinction that appears obvious, yet comes as a bit of a surprise: There is a distinction between abuse of power and abuse of influence. These are two ideal types of the “source of obligation” for fiduciaries
Abuse of power flows from the grant of power to the fiduciary. Abuse of influence flows from the limited consent of the beneficiary. For example, controlling shareholders were once understood as being able to abuse their corporate powers. Today, it is more common to focus on how they can “threaten the minority to say ‘yes.’” Duties to creditors follow from influence over them near the debtor’s insolvency but do not flow from an abuse of corporate powers.
Abuse of power emerges from the fact that fiduciaries have power that stems from their undertaking. They “are clothed with power.” (quoting Hoffman Steam Coal Co. v. Cumberland Coal & Iron Co., 16 Md. 456, 464 (1860)). What are the duties of being “entrusted” with power? A narrow answer is prohibition on various forms of self-dealing by trustees. A broader answer is to take as granted that fiduciaries have power and analyze “good faith” in the exercise of it.
Over the last half-century, according to Kershaw, a different source of obligation has emerged in courts: the “influence conception.” In this conception, the fiduciary relationship is that of principal and agent. It has a transactional base and the scope of the powers transferred is narrow. The fiduciary, moreover, has discretion to exercise a power only if its transfer is “truly voluntary.” It follows that any influence over the principal exercised by the fiduciary is suspect. Inquiries into whether there has been influence can become expansive, “subtle,” as is illustrated in decisions regarding special litigation committees and going private tender offers. The influence conception also allows for the expansion of the class of traditional doctrinal fiduciaries to include others who have influence, including parties to “confidential relations.” Furthermore, as the source of obligation has relational origins, individuals can be fiduciaries in some particularized matters, but not in related ones.
The influence conception of fiduciary obligations “has no limit” because “[e]verywhere … there are situations in which one person is in a position to detrimentally affect another.” Although judges limit it for pragmatic reasons, “the possibilities generated by the fiduciary influence conception will continue to serve the plaintiff bar … in generating a plethora of legal claims.” As we know, duties of loyalty and what constitutes informed consent can expand both extensively and intensively.
These two sources of obligation overlap. Kershaw documents cases in which the decision moves between the abuse of power and abuse of influence conceptions without comment. They can justify similar results. Despite accepting that fiduciaries have powers, particular exercises may be rejected because the fiduciary exercised “undue influence.” Determinations of undue influence can derive from both sources. Furthermore, the differences between them are minimized by understanding that the fiduciary has a very narrow remit. And good faith can be analyzed simply as a duty of loyalty.
A gap between the abuse of power on one side and undue influence on the other is the justified power of a fiduciary.
The two accounts are grounded in contrasting models of the fiduciary relationship. In the influence conception, serving a principal is to be servile. Fiduciaries only exercise justified power when they eschew being influential. The fiduciary of good character is a good listener. Fiduciaries in corporate law usually poorly fit this conception, as in fact they exercise rather unregulated corporate powers. Kershaw nicely depicts how this tension is a driver of today’s corporate law.
The abuse of power conception, on the other hand, is appropriate for powerful actors, the usual subjects of corporate law. Working as a fiduciary allows one powers that can be abused. The fiduciary of good character knows that their undertaking is not merely relational and has been shaped by both public and private forces. By this broad and open-ended remit, fiduciaries have been entrusted with moral, including political, authority. Louis D. Brandeis, for example, whose opinion in Southern Pacific Co. v. Bogert, 250 U.S. 483, 487-88, 491-92 (1919), states the abuse of power conception for corporate actors, practiced law as a powerful fiduciary, serving not client interests, but working as “counsel to the situation.”
Justifying fiduciaries’ exercises of power can depend on sympathetic understandings of their character, servile or moral as the case may be. Having public obligations, fiduciaries are neither free to totally disregard moral and political needs. But nor are they servants of the state. Human needs and democratically-determined goals compete with corporate loyalties. Fiduciaries make moral decisions by which they reveal themselves.
In thus reminding us of the source and nature of the power vested in corporate fiduciaries, Kershaw brings the character of the particular fiduciary back to the center of the description of corporate fiduciary relationships. The choice of which individuals become fiduciaries matters. Diversity, or the lack of it, may be highly consequential. Operating beyond beneficiaries’ consent, corporate fiduciaries’ characters influence their decisions and can become a subject of inquiry in contested actions.
This focus on character seems very old-fashioned. It is associated with a society that accepted inequality and unequal access to power. On the other hand, urgent needs may demand unconsented to exercises of power. ESG decisions, for example, may be better analyzed by inquiry into the morality of the fiduciary than into principal’s consent.
As in any excellent article, Professor Kershaw raises more questions than he can answer. He sets an agenda for inquiry into the modern relevance of the abuse of power conception of fiduciary obligations.
Stavros Gadinis and Amelia Miazad, A Test of Stakeholder Capitalism
, __ J. Corp. L.
__ (forthcoming, 2021), available at SSRN
Stavros Gadinis and Amelia Miazad’s thought-provoking paper, A Test of Stakeholder Capitalism, reveals certain shortcomings of the current academic debate on stakeholder governance.
Somewhat buried in a polarized corporate-purpose debate between shareholder primacy and stakeholder-centric perspectives is a novel narrative of evolution within companies. The authors note that the pandemic’s far-reaching and diverse effects on all types of companies and stakeholders offer a unique glimpse into corporate engagement with stakeholders. However, they caution that we cannot attribute the recent emphasis on stakeholders to the pandemic alone.
Instead, they argue, the pandemic has hastened an ongoing evolution: companies adapt to the complex business environment by developing mechanisms to proactively address stakeholder concerns as a risk management tool. Their collection and evaluation of stakeholder information is a process that ultimately enhances director oversight. Gadinis and Miazad capture this trend and illustrate how companies are becoming more sensitive to business risks, particularly those that are hard to predict; for example, various types of social and political risks.
The paper relies heavily on interviews with senior executives at companies that have relatively advanced stakeholder governance features. The authors recognize that all firms are not at the same point in their trajectory. The paper’s qualitative insights build upon the legal literature, offering nuanced illustrations of how companies use stakeholder information to weigh competing concerns in their decision-making processes. Stakeholder governance is viewed as a bottom-up process relying on private ordering and proactive information exchange, not top-down managerial or prescriptive regulatory efforts. Key takeaways from the paper are, first, that the primary benefit of stakeholder governance is an exchange between stakeholders and corporate managers that gives managers key information about stakeholder concerns and adds to the overall mix of information management evaluates. Second, stakeholder governance is in essence a risk management tool that improves boards and managers’ oversight of the corporate enterprise.
The authors propose that directors rely on private self-regulation to enhance both the amount and quality of information flow. They recognize an issue other scholars have observed: directors, particularly independent directors, must receive information from a broader range of sources than internal executives. Stakeholder governance addresses this informational disadvantage, placing boards in a better position to evaluate management strategies and navigate a range of other issues. After describing the information advantages associated with stakeholder governance, the paper sketches what stakeholder governance looks like in large, publicly traded firms or what it should look like. Its key features might include: (I) stakeholder engagement and disclosures; (II) board oversight and monitoring by executive teams; (III) collecting and evaluating stakeholder information; and (IV) leveraging outside professionals and third parties.
The authors caution against an overemphasis on the substantive outcomes of management decisions; that is, whether or not a particular decision favors stakeholders or shareholders. They observe that simply looking at outcomes may distort and discount the impact that stakeholder governance has on companies. Recognizing the importance of inputs and outputs, they focus on process, context, and mechanisms through which directors and managers balance a range of concerns.
Relationship to Regulatory Framework
Concerning corporate law and regulation, the authors advocate for a light touch, which, they believe is consistent with the corporate law framework and requires no significant change to state corporate law. The authors also contemplate disclosures that emphasize stakeholder governance processes instead of outcomes. This measured approach raises an interesting question: whether stakeholder governance obviates the need for the proliferation of social enterprise entities (e.g., Delaware public benefit corporations) because companies can balance various interests without changing the corporate form and still maintain the broad protection provided by the business judgment rule. Directors are unlikely to be liable for nonstakeholder-related decisions or lapses in stakeholder governance oversight, especially in the absence of regulatory or legal requirements. Nonetheless, the Marchand decision and its progeny signal a greater emphasis on risk management in the oversight context.
Some critics will wonder whether the authors’ definition of stakeholder governance goes far enough. They may question: (I) its reliance on processes, private ordering, light regulatory flourishes, and limited director liability; and (II) whether, by itself, it is sufficient to generate a stronger commitment from companies to balance and consider stakeholder interests. In response, some proponents may argue that the private-ordering response recognizes that stakeholder governance is not a one-size-fits-all approach to balancing and integrating stakeholder concerns. Different companies will have a range of stakeholders, affected in sometimes unique ways. Even if two firms have the same stakeholder considerations, they may not reach the same decision outcome.
Although stakeholder governance largely relies on internal mechanisms, the authors contemplate board and management reliance on third-party experts in addition to enhanced communication and engagement with stakeholders to ensure more timely information flow. They also anticipate that institutional investors, assisted by improved disclosures, will pressure directors to consider stakeholder issues. However, institutional investors are not uniform. They may support stakeholder considerations that differ from those of other members of a company’s investor base.
Legitimacy concerns may arise because stakeholder governance relies on self-regulation and affords directors broad discretion in balancing sometimes competing concerns. Sound processes provide a degree of procedural legitimacy to company actions, making them appear less ad hoc and more disciplined, but ignoring outcomes could also undermine another type of legitimacy based upon a putative “right” outcome. Companies, regulators, and academics wrestle with this issue: Is good governance simply a process or outcomes or both? Who should decide?
Connection to Risk Management
The paper does not dive deeply into all of the mechanisms that could be used to operationalize stakeholder governance. It does, however, discuss executive teams, board oversight, information collection, investor disclosures and engagement. A company’s risk management apparatus seems a fitting place for stakeholder governance to reside. Enterprise risk management has become the mechanism through which many large companies address financial and seemingly nonfinancial risks that may affect bottom lines and operations in myriad ways.
Evolving Expectations of Corporate Directors
The authors propose a measured approach to stakeholder governance, consistent with the way companies have adapted to a complex business and regulatory environment. A by-product of this evolution has been the enhancement of director duties. As companies develop more elaborate compliance systems in response to regulatory and legal complexity, stakeholder governance may prompt the creation of a separate corporate function and/or the rearrangement of corporate functions, board committees, and managerial teams responsible for incorporating it into company processes. This approach is consistent with a better-informed board engaging in objective decision making.
Does the paper propose anything new? Yes and no. Admittedly, companies have historically considered stakeholder-related issues in managing their business but largely in a reactive manner. As conceived in this paper, the value of stakeholder governance is in calling for a more proactive, structured, and routinized approach that can be evaluated and continuously improved. This is an important contribution.
The pandemic experience illustrates how companies might better incorporate stakeholder governance into their corporate frameworks and how the resulting information could be extremely important in sustaining profitability and navigating crises. From the authors’ perspective, stakeholder governance has at some companies enhanced “the ability of managers and directors to navigate a global pandemic” in a complex risk environment. They make a very compelling argument.
As efforts to improve the sustainability of corporate operations advance, growing attention has naturally turned to the form and degree of sustainability-related disclosures that large publicly traded companies are required to make. Various constituencies, including institutional investors, have increasingly demanded robust disclosures of information related to a range of environmental, social, and governance issues impacted by corporate activities. These matters are typically lumped together as “ESG disclosure” in capital-market parlance, and the U.S. Securities and Exchange Commission (SEC) has recognized the need for reform.
However, a host of vexing issues complicate such reform efforts. These include the degree to which current disclosure rules already reach such issues; the extent of reforms that could be pursued within the SEC’s market-oriented statutory mandate and financially driven conception of materiality; and – most significantly – the efficacy of disclosure-based regulation as a means of addressing complex global challenges like climate change. Modernizing ESG Disclosure, a recent paper by Virginia Harper Ho, tackles these weighty and interrelated challenges, providing detailed and nuanced analyses of where we stand, what the SEC could do within the current framework, and the more fundamental statutory reforms that would be required to produce an ESG disclosure regime more substantially contributing to the overarching goal of corporate sustainability.
Harper Ho observes that “many elements of the current federal disclosure framework should already elicit ESG disclosure in some form” – notably, those relating to risk. The lack of standardization and narrow focus on financial materiality, however, have led to under-reporting and heavy reliance on generic boilerplate. The result is a de facto voluntary regime characterized by limited information content and low comparability. In response, Harper Ho advocates adopting “a multi-faceted, tiered approach” that would balance specificity and flexibility by mandating disclosures “in three core areas that have been identified by investors as material to all companies” – climate risk, corporate governance, and human capital – and then “supplementing these core mandatory disclosures” with “principles-based approaches for sector-specific information.” This tiered approach has already been widely embraced globally, and Harper Ho offers a detailed “roadmap” for reforms along these lines that could be implemented within the SEC’s existing mandate, promoting fuller disclosure while containing regulatory costs through greater alignment with coalescing international standards.
In this spirit of disclosure, I should note that I personally tend toward skepticism regarding the merits of disclosure-based regulation; although robust disclosure is clearly an essential predicate for meaningful corporate reform, it too often substitutes for it. Harper Ho is clearly more optimistic about the potential for disclosure-based regulation as such, but the foregoing prompts me to emphasize another strength of her paper – its clear-eyed appraisal of the limits of strategies open to us within the current framework, combined with persuasive analysis of the structural reforms to the disclosure regime that would be required to promote more substantial reorientation toward corporate sustainability.
Harper Ho suggests that the reforms she advocates ought to be viewed as a “foundation” for a “comprehensive national strategy to address corporate environmental and climate impacts,” and she emphasizes that “ESG disclosure alone cannot create strong enough incentives for companies to undertake ESG risk mitigation, much less address climate change or drive a sustainable finance transition.” Ultimately, she urges Congress to consider “expansion of the SEC’s statutory authority to undertake rulemaking in the public interest,” construed broadly “to include environmental protection and sustainability goals” – an approach that in turn would require a broader conception of materiality. Here, again, international models and opportunities for improved global alignment present themselves. “The pace of sustainable finance reform worldwide,” she concludes, “demands bold action if corporate reporting is to meet the information demands of a future where sustainability information is available to the markets, where ESG risks are priced far more efficiently across financial systems, and where companies begin to internalize the full social and economic costs of their operations.”
Harper Ho’s paper tackles a complex regulatory terrain replete with hotly contested issues and thorny technical challenges. Clearly much work remains to identify the most effective means of achieving corporate sustainability, let alone how to implement them. Her rigorous analyses, however, bring much needed clarity regarding how the corporate disclosure regime might contribute, depending on the depth of reforms for which requisite political will exists. The result is a paper that is at once descriptively rich, practically useful, and normatively compelling.
The valuation of a shareholder’s interest in a corporation is a central issue in corporate law. In recent cases the Delaware courts have responded to appraisal arbitrage by limiting recovery in appraisal actions to deal price, deal price less synergy, or even market price unaffected by the deal. The cases have given rise to a literature of both praise and critique. Charles Korsmo and Minor Myers take the analysis a step further in What Do Stockholders Own? The Rise of the Trading Price Paradigm in Corporate Law, arguing that the implications of these appraisal decisions reach beyond appraisal to cases involving mergers more generally, and suggest an incipient paradigm shift in how Delaware law conceives of the (value of the) stockholder’s interest in the corporation: “[i]n a real sense, the Supreme Court in the appraisal cases has simply altered its conception of the public corporation as a form of property.” (P. 3.) The authors argue that the new paradigm is a negative development, essentially eliminating appraisal (which they see as a remedy with beneficial effects), reducing incentives for investors to buy shares in public corporations, and creating undesirable uncertainty about bedrock propositions of Delaware corporate law.
This is an important argument in a very readable and carefully argued article, one that is perhaps even more significant now, as appraisal is not the only area where the Delaware Supreme Court is limiting shareholder litigation. In the appraisal context the authors say it is not “the first time the Delaware Supreme Court has recently tried to hide sweeping doctrinal change beneath a veneer of “nothing-to-see-here” consistency.” (P. 4.) Brookfield Asset Management v Rosson and United Food and Commercial Workers Union v Zuckerberg have much the same feel.
If the market price of shares is the starting point for valuation of the shareholder’s interest in the appraisal context, why would this same approach not apply in other contexts? The authors suggest that the Delaware courts are now treating shares as goods such as toasters, rather than as a bundle of rights to a share of distributions, to votes on defined matters and to “compel directors to live up to their fidelity obligations” together with rights to bring derivative suits and access corporate books and records. (P. 7.) In addition to noting language in the appraisal opinions that “echoed the language of critics of Delaware’s traditional rejection of market price, declaring the identity of market prices and fair value as “economic fact,” (P. 5) the authors argue that the original conception of the shareholder’s entitlement developed in the context of appraisal and therefore appraisal is a natural context for the development of a replacement conception. The shift has implications for valuation in other contexts and for directors’ ability to defend against acquisitions. Delinking valuation in the appraisal context from other contexts would impair the coherence of Delaware corporate law.
The article traces the development of Delaware appraisal jurisprudence, in which the market price was a relevant factor, but did not answer the question of the value of “the entire corporate estate” or of “the corporation itself.” The authors also identify the same approach to valuation in other Delaware merger-related doctrines and they note that in some of the most notable merger cases in the last ten years the Delaware courts have looked to the “appraisal-based conception of stockholder entitlements” in assessing damages. (P. 16.) After a brief discussion of defensive measures the authors move on to discuss the recent appraisal decisions. The article considers, and rejects, the idea that the paradigm shift described is a mirage, and that the change will be limited to appraisal actions, noting that the change in the appraisal context was driven by a desire to reduce appraisal activity. There is much more here about the advantages of appraisal, and the disadvantages of rules that will make public company stockholding less attractive. But the core argument, that in fixing one set of problems the Delaware Supreme Court may have set in motion developments that will change Delaware corporate law significantly, is a must-read.
Cite as: Caroline Bradley, The Value of a Shareholding
(March 9, 2022) (reviewing Charles Korsmo and Minor Myers, What Do Stockholders Own? The Rise of the Trading Price Paradigm in Corporate Law
, 47 J. Corp. L.
389 (2022)), https://corp.jotwell.com/the-value-of-a-shareholding/
Emily Winston, Unequal Investment: A Regulatory Case
Study,__ Cornell L. Rev.
__ (forthcoming), available at SSRN
Between rising asset prices, high returns on investment, and yawning wealth gaps, the wealthiest equity investors have had a better run than most of us. What, if anything, is to be done about that? Should legal rules governing market structure reflect egalitarian commitments? Securities law scholars have considered this as an “investor protection” problem. A small but vocal line of thought has envisioned democratizing finance and reducing inequality by tinkering with legal rules like the “accredited investor” standard, or funds mediating access to private markets.
A largely unacknowledged assumption of this work is that egalitarian goals can be achieved by liberalizing access to risky financial assets. Professor Emily Winston’s article Unequal Investment: A Regulatory Case Study, forthcoming in Cornell Law Review, unpacks that assumption. She offers an important corrective to the intuition that fighting inequality involves loosening market-access restrictions and letting more investors share in the gains.
Winston draws on the work of economists like Thomas Piketty showing that wealth inequality widens as returns to capital exceed baseline growth of the economy. Securities law bears on this problem by gatekeeping access to high-return investments to the already wealthy. Investments available to the modestly wealthy are less risky and have lower expected returns. Not only do the wealthy have more money to invest, they “earn more per dollar invested” — a phenomenon Winston describes as an “accelerant to the growth of wealth inequality.”
Winston compares regulatory regimes governing investments of different investors. For many, wealth is tied up in ERISA-regulated retirement accounts. ERISA and securities law generally are solicitous of ordinary investors, assuming they are less sophisticated and more vulnerable. By contrast, securities law grants access to certain risky asset classes to the wealthier, assuming wealth is correlated with “resilience” (or ability to bear risk of loss). Winston illustrates with rules governing short sales. Because securities law practically limits access to these kinds of transactions to certain wealthier investors, it largely casts aside investor protection and attends to market quality indicators like price efficiency and liquidity. Yet regulatory initiatives that make it easier for companies to raise money can potentially increase risks to individual investors, because of depredation as well as simple adverse selection.
Winston offers a way of thinking about regulatory design that addresses markets as institutions to serve social goods, rather than as goods in themselves. Her primary contribution is to examine the misconception that “what is good for the financial markets is good for the economy.” Practices that appear to support strong and high quality markets may have broader macroeconomic consequences: “even well-functioning capital markets can fuel wealth inequality.”
A robust securities law would take these consequences into account. If differential access to capital markets grows wealth gaps, that has second-order problems for society and for undermining public confidence in markets in general. Efforts to increase market “quality” can encourage business models that are maladaptive and suboptimal measured by goals that reflect why we have markets in the first place.
Given the foundational role of securities law in shaping how public and private companies raise money and disclose ongoing operations, it should not be surprising that activists have increasingly seen it as an attractive tool through which to pursue greater democratic control over the economy. This is underscored by how much ESG investing has been a flashpoint over the scope of what the SEC is trying to accomplish. Getting that balance right is critically important.
Some might think the SEC should have already been accounting for these costs in its cost-benefit analysis after Business Roundtable. Yet Winston is urging a more radical step: putting a thumb on the scale against wealth inequality: “contributions to wealth inequality should count among regulatory considerations” in determining “how much of [a] practice should be permitted.” This, she says, would entail abandoning the agency’s current position “that more financial opportunities are better, so long as the markets are not harmed” — and to account directly for the role of financial regulation in contributing to wealth inequality.
One of the understated merits of Winston’s article is that it highlights the limits of kneejerk “increasing access to investment” as a tool for combatting inequality. If unequal access to investment opportunity is a driver of broader wealth inequality, then expanding the pool of people who can access particular investments will not alter the structural problem; they will just move the gate to let in a few more people, shifting where we allow the inequality gap to widen. As long as there exists unequal access to investment capital and to rates of return, there will be mathematically driven divergence in people’s wealth inequality. Regulators have to take into account whether tinkering with individual access to investment opportunities will be good in the public interest.
Focused on short selling, Winston’s paper is relatively modest in its stated goals. But if her framework were adopted, it’d have far-reaching and welcome effects. In particular, the SEC might abandon its perennial efforts to expand offering registration exemptions to balance capital- formation and investor-protection goals. Whatever the balance between those goals, Winston suggests it is undesirable for an underappreciated reason: the second-order consequences on wealth inequality will leave the impecunious even further behind, even if it reduces regulatory burdens for small and mid-sized enterprises. At the outer limit, we might imagine creating an institutional-only market, requiring retail traders to participate in diversified investment funds and prohibiting them from trading at all. This is already what we have in the secondary market for certain private placements under Rule 144A.
Winston’s paper does not imagine these futures directly. But she offers a creative framework for thinking about the unintended macroeconomic consequences of securities law’s market-access restrictions. Even if securities law is not now set up to take this into account, Winston suggests ways we might start to think of securities law in an image that is more democratically responsive and accountable.
US Treasury securities are to financial markets what carbon is to life on Earth—ubiquitous, foundational, indispensable, and acting very scary of late. “The Treasury market is the biggest, deepest and most important bond market in the world and acts as a benchmark that is used to price trillions of dollars of assets globally,” says the Financial Times, an authority on these matters—yet you would be hard-pressed to find half a dozen law review articles on the subject. A pair of papers by Yesha Yadav, most recently with (her dad) Pradeep K. Yadav, deserves much praise for starting to fill the gap. The papers properly frame the subject at the intersection of law, finance, and economics, while public and private sector “grandees” and “heavyweights” sound financial stability alarms and try to patch the fraying market architecture.
We have it on good authority that carbon is a relatively recent arrival in our universe; more so the US Treasuries. As recently as a century ago, the US Treasury Department was hawking versions of bespoke project bonds and struggling to emerge from Britain’s shadow in the financial markets. A succession of design choices in response to 20th century upheavals helped transform the US Treasury market from a fringe contender into the undisputed center of global financial gravity. Its centrality was on full display in October 2008 when frightened humans gorged on sticky pudding while the markets supplying their carbs scrambled for their own comfort food, the US Treasury securities.
Market response to the COVID-19 shock cast doubt on the Treasuries’ place as a safe haven. Governments and institutions scrambled for US dollars to meet essential needs and insulate themselves from turmoil—but they demanded cash and would no longer settle for the US government IOUs. With financial markets on the fritz, the US Federal Reserve intervened, buying $1.5 trillion in US Treasuries with crisp new cash in March and April 2020. Following its recent crisis playbook, the Fed launched, revived, and extended dollar liquidity facilities for all manner of wholesale market participants and foreign central banks. Implicitly recognizing that the risk of another “dash for cash” was here to stay, the Fed established standing repurchase facilities in July 2021 to reassure domestic, foreign, and international investors that their Treasuries were as good as cash. But there is not one magic pill to restore Treasury greatness.
Yadav’s two articles focus on the elaborate and apparently fragile institutional design underpinning the Treasuries’ global role. The first puts some of the dysfunction to the long history of opacity, regulatory fragmentation, and misaligned incentives in the US government debt market. It argues for better interagency coordination through the Financial Stability Oversight Council (FSOC) and central clearing, a form of mutualization that should incentivize market participants to do the right thing. The second article (joint with P.K. Yadav) highlights Treasury market fragmentation and the increasingly problematic role of primary dealers, the large financial institutions that serve as the New York Fed’s counterparties in buying and selling Treasury securities. The article’s recommendations include more and better information reporting, more robust consolidated oversight, and constraints on primary dealers’ ability to quit in bad times.
The information and coordination problems the authors identify seem right, and some of their prescriptions are ahead of the curve. I see the most valuable contribution of both papers in helping disentangle questions about the government debt contract and its safety from questions about the safety of the market in which it trades.
Answers to the contract questions are mostly straightforward. As a debt contract, the US Treasury looks goofy (the promise to repay is filed under “Miscellaneous”); like all government debt, it would be very hard to enforce. Indeed, the crucial bottom-line question of whether the US Treasury could default (stop paying its debt) gets an emphatic answer – of course it can, and it has, and everyone knows it. The 2021 debt limit drama adds an unnecessary data point for extra credit.
The more interesting questions concern the market – how the United States managed to grow a market where questioning its debt was taboo, and to invest vast networks of people and institutions around the world in maintaining the legal and market fiction of the debt’s absolute safety, the original and ultimate too-big-to-fail. The answers are long and complex.
Even when the United States was, in today’s terms, a frontier market in default, Hamilton and allies had sought to make its debt more than a funding instrument. It was supposed to be money, political glue, and a social and economic organizational device rolled into one. From the start, the Treasury cultivated a mix of domestic elites and foreign investors. Foreigners, most notably foreign central banks, today hold about a third of all tradable Treasury debt, tied to the US dollar’s role as the global reserve currency. Tax administration, monetary policy, bank and market regulation, and even bankruptcy laws were designed around Treasury circulation. The shadow banking system, collateralized with Treasury debt, grows out of the original design. The Treasuries’ “safety” has always been about their many functions in the broader institutional and political context—more than the present value of future cash flows. By the same token, Treasury market regulation is not about the issuer; it is all about the scaffolding around the hollow core.
The Federal Reserve has intervened to buy Treasury securities before, when it got especially worried about gaps between cash and Treasury securities—notably when Hitler invaded Poland in 1939. Is today’s persistent Treasury market turbulence the start of something different? Who knows? Curiously, foreign central banks were among the biggest sellers of US Treasury securities in March of 2020. Although the Fed responded on a massive scale, the jitters keep coming, along with big storms, and sticky pudding is back in vogue.
Professor Yadav’s two articles and the research agenda they set are perfectly timed. I hope law scholars stay engaged in this space, preferably across disciplines – extra points if you can get your family to come along.
Anna Gelpern, The Elephant in the Room, JOTWELL (October 12, 2021) (reviewing Yesha Yadav, The Failed Regulation of U.S. Treasury Markets, 121 Columbia L. Rev. 4 (2021). Pradeep K. Yadav and Yesha Yadav, Fragile Financial Regulation (Sept. 9, 2020), available at SSRN), https://corp.jotwell.com/?p=1485.
Robert Miller, Stock Market Value and Deal Value in Appraisal Proceedings
, 96 Notre Dame L. Rev.
1403 (2021), available at SSRN.
Delaware’s law of appraisal rights has been in an uproar since hedge fund arbitrageurs showed up in the Chancery Court fifteen or so years ago as appraisal petitioners. The shock led to minor changes in the statute and extensive changes in the caselaw. Responsive commentaries continue to appear with regularity. Professor Robert Miller takes a fresh look at the situation in Stock Market Value and Deal Value in Appraisal Proceedings. His paper is well worth a look.
I need to back up those fifteen years in order to frame the paper. Appraisal arbitrage really changed the game. All of a sudden a notoriously plaintiff-unfriendly legal remedy became a play space for Wall Street smart money looking for Alpha. The arbs worked the system by cooking up persuasive discounted cash flow (DCF) valuations that came in above the merger price. Shareholder advocates saw much to like in this development. The Delaware bar and judiciary, along with most of the rest of the establishment, saw things differently. The bar pushed through some minor revisions of the statute through the legislature, but those were not enough to stop the show.
It was left to the bench to shut down the arbs. It rose to the occasion. In a series of decisions—Dell, DFC, Aruba Networks, Jarden, and Stillwater—Delaware’s Chancery and Supreme Courts rewrote the playbook for the legal determination of “fair value.” Since the 1983 decision of Weinberger v. UOP, fair value had been the preserve of financial experts presenting state of the art analyses employing DCF, comparable companies, and comparable mergers methodologies. The recent cases leave the door open for such presentations. Their innovation lies in the introduction of two new alternative routes to a fair value result—the merger price (minus synergies) and the pre-merger market price. The decisional pattern makes it clear that the merger price (minus synergies) is preferred to the old analyses, even as the cases also make it clear that approaches to fair value are to be made on all the facts of the particular case. The status of market price is less clear, but it now certainly has a place on appraisal’s methodological menu.
Merger price (minus synergies) and market price hold out two great advantages. First, they are transactionally-based rather than hypothetical. They as such warm law and economics hearts—Jonathan Macey and Joshua Mitts have taken the occasion to strike a blow for the Efficient Market Hypothesis and make the case for elevating market price over merger price. Second, whether the court goes for merger price (minus synergies) or pre-merger market price, it pulls the rug out from under appraisal arbitrageurs. Why incur litigation costs to come home with merger price minus synergies? You can get a higher figure (merger price with synergies) by doing nothing. Worse, why run the risk of getting pre-merger market price—a sucker payoff that cuts off all access to the merger premium? The answer is that you don’t run the risk. Appraisal arbitrage is now dead as a door nail.
But where does this leave “fair value” as a matter of legal theory? The pre-arbitrage law review literature speaks emphatically on this topic. Per articles by Bill Carney, Rich Booth and Michael Wachter and Larry Hamermesh, the appraisal petitioner is entitled to a pro rata share of the pre-merger going concern value of the company as opposed to a pro rata share of the company’s value in a third-party sale. Taking this principle to the new world in which the judge chooses between merger price (minus synergies) and pre-merger market price, market price emerges as the choice, as Macey and Mitts have made abundantly clear.
Let us now turn to Professor Miller. He gives us the background with dispatch and then turns to the merger price/market price binary. The search, he reminds us, is in part for a credible figure susceptible of clear proof. Unfortunately, both figures present evidentiary problems despite their hard origins in actual transactions. Merger price presupposes a fact-intensive, Revlon-type showing of a solid sale process. Although this inquiry is factual and the applicable standard is open-ended, fair value is not the issue. The fair value problem arises when the quasi-Revlon test is passed and the synergies to be deducted from the merger price (as required by Delaware section 262) must be calculated. Unfortunately, the synergies are unlikely to show up clearly. Recourse must be made to guesstimates based on expert testimony, which is just the territory the new regime tries to avoid entering. There is also a threshold test respecting market price—a deep, “efficient” market must be shown affirmatively. Once efficiency is established the question is whether the pre-merger price failed to reflect undisclosed material information, information that might well have influenced the negotiated price. Miller holds the plausible view that this often will be the case, again leaving us in an evidentiary morass.
Miller then takes up the old recurring question: Is the appraisal petitioner entitled to a cut of the merger premium? He addresses the question with a broad review of the economics of merger premiums. The discussion shows that the literature’s consensus view—that the premium follows from an allocation of expected synergies and gains from agency cost reduction—does not exhaust the field of possibilities. For example, some bidders (particularly strategic bidders) just overpay. Moreover, in any given merger, there will be deal-specific mix of contributing factors. What then is legal theory, which needs a straightforward set of descriptive assumptions, to do?
Professor Miller turns to the downward sloping demand theory of merger pricing. Under this, different shareholders value the company differently, with the lowest valuing holders selling into the pre-merger stock market and with higher valuing holders holding out for their higher reservation prices. The acquirer pays a premium because it must go up the demand curve, offering a sufficiently high price to garner the support of a majority of the shares. By hypothesis, the appraisal dissenter comes from the minority of holders with higher-still valuations.
As Professor Miller notes, the downward sloping demand explanation is simple, complete, and intuitive. Its even there in the law review literature, the subject of distinguished papers by Lynn Stout and Rich Booth, published in 1990 and 1991, respectively. Why then does it have the status of a discarded minority view? As Professor Miller shows us, it is quite consistent with the law of one price. But it also is inconsistent with orthodox financial economic theory, which holds that security pricing has a flat demand curve. Stocks and bonds are not consumed, like widgets. They provide payment streams that finance the consumption of widgets and other goods and services. Demand for money is constant—people always want it. When a stock goes down it is not because demand for the money on offer has decreased, it is because less future money is now projected or the same monetary projection has become a riskier proposition. Portfolio theory backs up this insight with its showing that rational investors will hold stocks in a single optimal market portfolio, addressing their variant tastes for risk as they interpolate risk-free treasuries into the investment mix.
Professor Miller confronts this problem, showing us that downward sloping demand can be interpolated consistently with cutting edge financial economic thinking. In so doing, he draws on the growing corpus of heterogeneous expectation models of stock pricing. The cites are apt. Supply and demand are now factors on the table in the advanced financial economics of stock market pricing.
Professor Miller’s paper is important because it cuts sharply against a consensus view, offering a clear-cut, theoretically-backed alternative that implies higher payouts to appraisal petitioners. It will not by itself displace the consensus. But it destabilizes the consensus, depriving it of the illusion of full-dress support in high church financial economic theory. The appraisal world emerges a more complicated place than ever, and that’s a good thing.
Professor Miller, by the way, is an excellent writer. He is above all else succinct. He accomplishes this presentation in just under seventeen law review pages. I couldn’t have done it in fifty. Of course, I would have added some stuff in those extra thirty-three pages. But not all that much.
Cary Martin Shelby, Profiting from Our Pain: Privileged Access to Social Impact Investing
, 109 Cal. L. Rev.
__ (forthcoming, 2021), available at SSRN
“Doing well while doing good” has become the mantra for a large segment of investors in today’s capital markets. In the wake of COVID-19, the Black Lives Matter movement, and the increased focus on climate change, many investors today are looking for ways to use their capital to positively impact society and address its various challenges. Responding to this demand, various socially conscious investment vehicles have emerged, such as environmental, social, and governance (ESG) investments, socially responsible investments (SRI), and social impact investing. But as these investments grow in popularity and size, it becomes necessary to question whether they are truly having the positive impact their name suggests.
In Profiting from Our Pain: Privileged Access to Social Impact Investing Professor Cary Martin Shelby explores the underbelly of socially conscious investment, focusing specifically on social impact investing. Social impact investments “seek to positively impact the environment or society at large, while simultaneously yielding a return for the underlying investors.” Because of its express and specific focus on social impact, this type of investing has the greatest potential for generating positive results for targeted communities. Yet, despite the potential benefits of social impact investing, Professor Martin Shelby argues that the public-private divide in U.S. federal securities laws creates opportunities for elite investors to profit at the expense of marginalized communities. This occurs through two interrelated yet distinct ways.
First, most social impact investments are private offerings, placing them outside the mandatory disclosure regime applicable to public offerings. The lack of disclosure allows social impact investments to obscure potential negative externalities that accompany their activities. Professor Martin Shelby notes that in “solving” one problem, social impact investments may only exacerbate other issues within the communities they claim to assist. Or, alternately, these investments may fail to achieve a positive impact and then be abandoned, leaving the affected community to clean up the resulting mess.
Second, due to the nature of the investment vehicle, only specific types of investors can participate in social impact investments—elite, wealthy investors who are unconnected to both the community and the problems to which their investments are directed. Exclusion from the investment process deprives the persons and communities most affected of means to provide inputs on the issues in question, further marginalizing them. Additionally, these marginalized groups are unable to share in the profits generated from the commodification of their community pain. Both factors serve to “increase the collective ‘pain’ experienced by disadvantaged communities” and obscure the magnitude of the resulting harms.
Professor Martin Shelby’s insights are both relevant and poignant. Social impact investing and other forms of socially conscious investments are only likely to grow in the coming years as there is a greater demand from investors to “do good” with their investments. This makes it all the more important to recognize that social impact funds may result in negative externalities that undercut the very “good” they are supposed to accomplish. Examples of such negative externalities include: (i) clean energy investments that destroy a surrounding habitat; (ii) displacement of lower funded but higher quality products that would have a greater level of impact than their replacement; and (iii) gentrification.
Professor Martin Shelby proposes regulatory reform and intervention to address these negative externalities. She proposes closing the public/private divide in securities laws applicable to social impact funds, stating: “Categorizing funds as private simply because they are restricted to elite investors who can fend for themselves no longer works in a world where their investments can generate massive negative externalities.” Her proposal is to create a new series of exemptions under the Securities Act of 1933 and the Investment Company Act of 1940—the Social Impact Exemptions. The proposed exemptions change existing rules related to disclosure and access and create new mechanisms to increase accountability and community involvement and expand management structure.
Professor Martin Shelby’s proposals aim to increase regulatory and community involvement in addressing the harms that accompany social impact funds. She recognizes that social impact funds need regulatory flexibility to invest in illiquid and possibly short-term unprofitable ventures, but she proposes providing this flexibility in exchange for compliance with the new framework. Professor Martin Shelby’s proposal is nuanced and practical. And, importantly, it addresses the ways in which marginalized communities are excluded from participating in or profiting from the commodification of their collective pain, while minimizing the likelihood that these same communities are left to deal with the negative consequences of wealthy investors trying to “do good.”
Professor Martin Shelby’s exploration of who gets to profit from the commodification of marginalization is both nuanced and necessary at this juncture. Impact investing is poised only to increase as ESG, SRI, and social impact investing increasingly become mainstream. However, the ability of impact investing to operate opaquely, passing off negative externalities to already disadvantaged communities is an under-explored issue that is rooted in the federal securities laws’ notions of “publicness.” Ensuring that social impact investing does not result in significant harms for the communities they claim to serve requires a holistic approach of more disclosure, innovative community access, better accountability, and a broadened management structure. If investors truly want to do well while doing good regulators must first ensure that these investments do not exacerbate existing harms, expose communities to additional risks, or operate to the exclusion and detriment of the persons they’re supposed to help.
Peter Molk and D. Daniel Sokol’s recent article The Challenges of Nonprofit Governance addresses a less-examined area of the governance literature: namely, the governance of nonprofit organizations. As the authors note, nonprofit governance failures have made the news in the past few years, as with, for example, the allegations against the National Rifle Association for self-dealing and fraud, or those against the University of Southern California related to sexual assault, discrimination, and corrupt admissions dealings. This article fills a notable gap in the governance literature by addressing important differences between corporate and nonprofit governance mechanisms; discussing currently available methods to monitor nonprofit activities, as well as the shortcomings of those approaches; and proposing solutions to promote more robust oversight and to better safeguard the interests of the nonprofit stakeholders and beneficiaries, as well as those of the general public.
Molk and Sokol identify several issues inherent in and unique to nonprofit governance. State attorneys general are usually tasked with nonprofit oversight. The authors note that such monitoring is often hampered by a lack of resources, as well as a dearth of required financial disclosures that could be used to evaluate nonprofits’ fiscal health. The authors attribute these shortcomings to the structural flaw that nonprofits may operate in numerous states, but that the mission of an individual state attorney general centers primarily around the protection of citizens of only its own state. As such, a problem of the commons arises whereby the resulting observed level of enforcement is less than would be optimal, but no one state attorney general has sufficient incentive to increase enforcement to detect wrongdoing outside of its own jurisdiction.
As the authors note, nonprofits are required to make various disclosures by way of IRS Form 990, with more extensive disclosures required depending on gross receipts and/or total assets. These forms, however, are not made public until at least a year after filing. Moreover, the IRS’s mission is focused on ensuring the collection of taxes, not ensuring good governance; as such, nonprofits without preferential tax treatment escape IRS scrutiny, as do nonprofits suffering from governance issues that do not relate to the misuse of funds as relevant to the tax code.
Nor do conflict of interest policies, where they are in place, always adequately protect nonprofits form director self-dealing. The authors identify numerous shortcomings in conflict of interest policies as implemented by nonprofits, which may include the lack of written policies, the absence of a requirement that conflicts be disclosed, and insufficient monitoring and enforcement of conflict of interest policies.
The authors propose a variety of solutions to address these nonprofit governance issues. For example, they propose mandating enhanced disclosures in order to allow for reputational penalties that would deter poor governance practices. They also call for third-party private certifications to signal and verify good governance structures and practices. Most significantly, they call for a unified system of nonprofit monitoring by state attorneys general, much as the insurance industry is regulated at the state level but subject to coordinated minimum solvency standards across states. The authors argue that this system is preferable to designating the IRS as a monitor, due to IRS understaffing and a mismatch between the IRS purpose of tax collection and the broader evaluation of robust governance that the authors envision. The designation of the particular state tasked with oversight would depend on either the state of incorporation (the authors’ favored approach) or the state in which the nonprofit’s operations are most significantly located.
The authors envision that allowing nonprofits to essentially select their own set of monitors and applicable law will lead states to develop a robust set of nonprofit legal protections, much as allowing corporations to choose applicable state law depending on their state of incorporation has led to Delaware’s development of business-favorable corporate law. Challenges to this proposed system including defining the scope of oversight and preventing a race to the bottom (namely, laws that allow for minimal oversight of nonprofits).
The authors note the importance of the nonprofit sector to the American economy; as they state, nonprofit organizations total 5.6% of U.S. GDP and employ twelve million people. The examples of nonprofit governance failures cited by the authors—as well as a slew of others—highlight the pressing need to remedy poor governance issues at nonprofits. Molk and Sokol’s article presents helpful, creative solutions to these issues.