Stavros Gadinis and Amelia Miazad, The Hidden Power of Compliance
(Feb. 14, 2018), available at SSRN
In business and government, today, bureaucrat is a pejorative. Bureaucracy rather than being a mark of rationality is sneered at. Multi-disciplinary project teams, flat hierarchies and “intrapreneurship” are what corporate consultants prescribe. At least since Thatcher and Reagan, market mechanisms have been praised as superior to the civil service.
Yet, corporate legal regulation can only think in bureaucratic forms. In Europe, the GDPR requires a new C-suite member, the Chief Data Officer. In the U.S., executive, legislative and judicial actions, well described in this article, have resulted in “the explosive growth of compliance departments.” (P. 7.) In legal regulation, authority is vested at the top and liability at the top is thought to ensure compliance. As scandals occur because those at the top failed to confront problems, the law envisions new staffs being created so that the top of the bureaucracy can issue orders resolving the problems. Previous work has been skeptical of whether the development of compliance departments will lead to actual compliance. Gadinis and Miazad report on various law review articles in which “the harshest critics view compliance as a box-checking exercise, too formalistic.” (P. 2.) Others complain that those in the department won’t be able to “supervise their superiors.” (P. 2.) In other words, they will be inferior bureaucrats. Without being explicit about it, often using agency-cost theory, these law review articles apply the critique of bureaucracy so prevalent in our culture to criticize the organizational technique of compliance departments.
Gadinis and Miazad cut through these critiques and argue that the principal function of compliance departments is to put red flags in front of the board. One might quibble with this approach by emphasizing the educational function of compliance departments, improving how lower-level employees exercise their powers. But, in consonance with corporate law’s emphasis on power at the top, Gadinis and Miazad propose that whoever leads the compliance department (sometimes a Chief Legal Officer, but increasingly a Chief Compliance Officer) be in the C-suite and have clear lines of authority to communicate to the board. The threat of liability, they assume, will incentivize chief compliance officers to report to the board.
Gadinis and Miazad’s insight is to describe the problem facing the law as deciding “where the board faces a substantial risk of liability” and where the “chief legal or compliance officer faces a substantial risk of liability.” (P. 40.) Reviewing both Delaware and Federal law, they show that the board has a high risk of liability when it culpably ignores the red flags and that the chief compliance officer has a high risk of liability when she knew of red flags and failed to communicate them to the board. But the situation is not always so clear cut.
The great pleasure of this article is that the authors create a 2×2 matrix of low and high risk of liability for boards, on one axis, and chief compliance officers, on the other. They label the four situations as ones in which non-compliance is “untraceable,” “traceable,” “interrupted,” and “incomplete.”
“Untraceable” non-compliance occurs when the problems escape the due attention of both the compliance officer and the board, which is how the authors interpret what happened at GM during the 12 years of non-recall of a fatally defective ignition switch, despite repeated individual cases that GM settled. According to the authors, in “untraceable” non-compliance, neither the board nor the head of the compliance department are liable.
“Traceable” non-compliance occurs when the compliance department has reported to the board and the board chooses to ignore the red flags. In the WaMu Mortgage Meltdown, the board was informed of the risks, but chose not to act, creating its liability, but not that of the compliance officer, even though the compliance department did not stop the underlying actions.
“Interrupted” non-compliance occurs where the compliance department is aware of the non-compliance but doesn’t report it to the board. The authors recount this happening at Yahoo, which in 2014 had what was then the largest data beach in history. The authors don’t explain why the General Counsel failed to involve the board, but by doing so he incurred liability.
“Incomplete” non-compliance occurs when the compliance department communicates some of the facts to the board, but in such a way that when the scandal erupts the board claims “that they were ‘blindsided.’” (P. 51.) The authors interpret the fake accounts saga at Wells Fargo in this manner. Muddled awareness by the board and obfuscating reports to them by the compliance department, according to the authors, potentially lead to liability for both. The authors don’t explain why the Wells Fargo compliance department acted as it did, but describes that it escaped liability, as did the board, although the board had to undergo some stress in proving its lack of scienter.
These distinctions are lucid. But it might be emphasized that in all categories, except “traceable” noncompliance, the board was protected. In all but “interrupted noncompliance,” the chief compliance officer was protected. In all these cases, lower level employees, in and out of compliance, were the normal fall guys. Many were fired and only rarely was the CEO terminated.
It also might be emphasized that except at WaMU, the “traceable” case, the compliance department did not signal red flags to the board. At GM, the red flags were not even signaled to the General Counsel, its chief compliance officer at that time. The General Counsel was kept ignorant because he delegated to his staff the settlement of all cases for $5 million or less. The legal department of GM empowered lower-level attorneys, and all the cases settled within their limits. Especially in flat organizations, information does not necessarily get to the top, but also in bureaucracies, no one wants to be the messenger of bad news. Failing to report to the board may be a result of the chief compliance officer making her subordinates aware of how she is to be protected or it may be that the chief compliance officer knows that the board expects her to fall on her sword.
The emphasis of this article is on designing organizational structures where people want to be messengers of bad news. In the one case where the board was apprised, WaMu, the board had “already run through nine chief compliance officers in just seven years.” (P. 45.) I doubt that this frequent firing makes for a desirable organizational strategy because it could frighten the chief compliance officer into failing to report the problems to the board. But there also can be incidental benefits. In my opinion, the tenth one felt no loyalty to the company or the board and that is why he put the board on the hot seat.
Organizational loyalty can make one a bad gatekeeper, but it more importantly may induce a chief compliance officer to choose to incur liability. Where once, the Chief Legal Officer was “the vice-president in charge of going to jail,” now that task may have shifted to the chief of compliance. As the authors point out, “going to jail” is hardly ever the problem. Losing golden parachutes and claw-backs of bonuses are the risks that chief compliance officers may feel is part of their job. When one chief compliance officer suffered liability, at Yahoo, the “interrupted” case, other Silicon Valley GC’s explained that he was “The Fall Guy.” (P. 48.) True, and he probably thought that was his job. General counsels and chief compliance officers may feel that non-compliance is their territory and it is their problem to deal with. As a General Counsel once told me, she knows that she stands at “the coalface” and it is her job to handle the problem, not the board’s.
The bureaucratic instinct is a territorial one: this is my job and my station. In response to “incomplete” non-compliance, where the full story was not told to the Wells Fargo board, the compliance department was increased by over 5,200 employees (P. 52.) Obfuscating reports may risk subjecting the chief compliance officer to liability for maintaining an inadequate system, but they also create the possibility that a larger department may result. Suggesting that there may be red flags out there, but not planting them at the board, may be in the interest of both the chief compliance officer and the board.
As the authors note, there “is wide variation in structure, powers, and resources available” to compliance departments (P. 53.) As they also note, these organizational differences may have profound consequences not only on the “new actors” (P. 52) but also on “the institutional makeup of compliance.” (P. 53.) The authors call for “empirical studies of successful compliance operations.” (P. 53.) The weakness of this article is the authors’ review of the extant empirical literature on this topic. Although the authors quote various law review articles, they do not mention work, such as that being done at their institution by Lauren Edelman on Human Resources Departments, or, for example, on Australian compliance departments by Christine Parker and Vibeke Lehmann Nielsen. For Gadinis and Miazad, organizational problems arising in connection with compliance departments are new ones. Although their perspective on compliance is new and exciting, I would suggest as a partial critique of the many pleasures of this article that we do have some knowledge of how corporate staffs function. Joining what we know about how corporate staffs operate to the unique approach of Gadinas and Miazad will only enhance the many pleasures of this article.
Shaanan Cohney, David A. Hoffman, Jeremy Sklaroff, & David A. Wishnick, Coin-Operated Capitalism
, Columbia L. Rev.
(forthcoming 2019), available at SSRN
So-called “initial coin offerings,” or ICOs, are the new IPOs. In the last two years, ICOs became one of the hottest new investment opportunities in the rapidly growing market for crypto-assets—and one of the hottest topics of discussion among policy-makers and capital markets experts. Just like everything else that belongs in the general category of “fintech,” ICOs are fascinating and mysterious to most of us, legal scholars. What exactly are these “tokens” or “coins” that are being sold to investors in lieu of the traditional shares and bonds? Are they investment contracts, products, or club membership cards? Are they money? Should they be regulated, and under what set of rules? These are just some of the questions the acronym “ICO” triggers in the lawyer’s restless mind.
In a new article, cleverly titled Coin-Operated Capitalism, a team of authors with varying expertise (including a computer scientist and a scholar of contract law) explain ICOs by using an example of Coca-Cola raising money for its network of vending machines by issuing tokens to be used for purchasing cans of coke from those machines. Unlike the imaginary Coca-Cola project, however, ICOs involve purely digital “tokens” and “machines” that reside on blockchains and are embodied in software codes. As the authors explain, the key forms of this software—known as “smart contracts”—are encoded “if-X-then-Y” rules that govern the functionality of specific tokens sold in individual ICOs. To many ICO (and, more generally, crypto-tech) enthusiasts, this fully automated functioning of the issuer-investor relationship is a great virtue: by eliminating the need to trust humans, smart contracts supposedly eliminate the possibility of fraud or other misbehavior by company managers and insiders enjoying significant informational advantages over outside investors. In this techno-utopian narrative, there should be no need for legally mandated disclosures, regulatory oversight, or court enforcement of investors’ rights: the software code would simply deliver the results intended by the contracting parties, in an impeccably efficient and transparent manner.
Coin-Operated Capitalism puts this techno-utopian narrative to test. The cross-disciplinary team of the article’s authors reviewed disclosure documents—or “white papers”— issued in 50 ICOs that raised the most amount of capital in 2017. In each case, they examined three key dimensions of the relationship between ICO promoters and investors: (1) the limits on the supply of the relevant tokens (which is important from the viewpoint of tokens’ value); (2) vesting requirements and other restrictions on the insiders’ ability to sell or otherwise monetize their tokens; and (3) the ability of the ICO promoters to change the terms of the contract after the tokens are sold to investors. In each case, the authors reviewed both what the relevant white paper disclosed to the investors, and what was actually programmed into the relevant code. Their inquiry focused on whether or not the software governing the relevant tokens was written in a way that would deliver on the white paper’s promises. Perhaps not surprisingly, the results of their empirical testing revealed that “ICO code and ICO disclosures often do not match.” To put it simply, what investors were told would happen in future might never materialize because the governing software was simply not written to produce the expected outcomes. Furthermore, the authors found no evidence that ICO markets effectively priced this absence of investor protections from the code.
The authors use these fascinating empirical findings to raise a number of important questions about ICO markets. They ask, among other things, whether the code is not quite as important as ICO enthusiasts portray it to be, and whether the ICO markets are fundamentally broken. I won’t attempt to spoil your fun, however, by previewing their conclusions. I am sure you will enjoy following the authors’ thoughtful arguments and pondering the questions they pose as much as I enjoyed doing so. I also hope this deliberately empirically grounded article will make you think about such “big” normative questions as the changing role of law in our increasingly decentralized, computerized, and automated world. This article does not purport to answer such “big” questions but it does help us get a bit closer to that goal.
Cite as: Saule T. Omarova, Understanding ICOs: In Code We (Shouldn’t) Trust?
(May 2, 2019) (reviewing Shaanan Cohney, David A. Hoffman, Jeremy Sklaroff, & David A. Wishnick, Coin-Operated Capitalism
, Columbia L. Rev.
(forthcoming 2019), available at SSRN), https://corp.jotwell.com/understanding-icos-in-code-we-shouldnt-trust/
Jennifer Hill, Legal Personhood and Liability for Flawed Corporate Cultures
, European Corporate Governance Institute Law Working Paper No. 413/2018 (2018), available at SSRN
In Legal Personhood and Liability for Flawed Corporate Cultures, Jennifer Hill provides a thought-provoking, comparative perspective on corporate accountability for misconduct arising from defective culture. Recent scandals involving Volkswagen, Wells Fargo, Uber, Fox News, CBS, and others make clear that culture can contribute to malfeasance that damages both company and societal bottom lines. Such scandals raise key corporate governance questions: (i) how should the law address widespread intra-firm wrongdoing as a matter of criminal and civil liability?; and (ii) should the law target the organization, the senior executives and directors, or the individuals (i.e., “bad apples”) who commit wrongful acts?
The paper compares US, UK, and Australian approaches to two types of liability: (i) entity criminal liability and (ii) individual director and officer liability for breach of duty. The analysis highlights jurisdictional differences and similarities that determine each regime’s ability to promote accountability for misconduct arising from flawed corporate cultures. It also examines the influence of the theoretical lens through which scholars view liability for flawed corporate cultures. Aggregation theories (e.g., nexus of contracts), viewing the corporation as a legal fiction composed of natural persons, create barriers to entity liability. (Pp. 9-14.) By contrast, entity-based theories, viewing the corporation as a separate legal person, can be used to secure legal rights for corporations on the one hand and impose duties on the other. This analysis finds that entity-based theories are better-suited to address accountability for flawed corporate cultures than aggregation theories of the corporation because they: (i) can overcome accountability problems where it is difficult to identify individual wrongdoers; (ii) address diffuse, opaque, and complex operations more effectively; (iii) minimize scapegoating of lower-level employees to protect senior management; and (iv) incentivize self-regulation to avoid liability.
Entity Criminal Liability for Wrongs Arising from a Flawed Corporate Culture
The paper asserts that despite their different historical development, the US, UK, and Australian approaches all allow for entity criminal liability. (Pp. 14-19.) However, it finds no coherent theory of criminal liability across jurisdictions, especially with respect to misconduct stemming from a flawed corporate culture.
Civil Liability of Directors and Officers for Wrongs Arising from a Flawed Corporate Culture
At first glance, the US and UK approaches to director liability for breach of duty appear different, but in practice, they both significantly limit it. In contrast, Australia has an active public enforcement regime: the Australian Securities and Investments Commission brings actions against directors for breach of duty with a degree of success. Australian courts and regulators increasingly view directors’ duties as public obligations with important social functions, and this raises director liability risks for overseeing flawed corporate cultures.
Process versus Culture
The paper highlights a number of common scenarios involving cultural breakdowns; for example, (i) low-level employees commit wrongful acts in response to encouragement and firm-wide directives from senior management (P. 9); and (ii) high-level employees engage in malfeasance that results, not from perverse incentives, but inadequate policing of the company’s culture. The Wells Fargo fictitious accounts scandal reflects the first scenario, and recent sexual harassment scandals at CBS and Fox News, where harassment by senior employees deemed too important to the organization was tolerated, reflect the latter. Although within the US corporate-law context (i.e., Caremark and Stone v. Ritter), directors and officers are unlikely to face liability for breaching their oversight duties due to flawed corporate cultures, they ostensibly set a cultural and ethical tone for the entire organization. Flawed corporate cultures may impede effective management of legal compliance, risk, and corporate malfeasance. The failure to account for flawed corporate cultures, irrespective of legal liability, risks damage to company and societal bottom lines.
The legitimacy of US-based corporate law is often judged from a procedural perspective, with procedures serving as a heuristic for quality governance, but procedures do not necessarily capture important cultural and behavioral dynamics. For example, a common feature of most corporate compliance programs is an employee code of conduct that serves as a written reflection of a preferred culture and behaviors. When unwritten rules, practices, and patterns undermine it, directors and officers are unlikely to be held liable as long as they did not have knowledge of wrongdoing, and officially sanctioned written procedures were followed.
Culture is an anthropological concept. The paper acknowledges that the corporate governance literature views it as “slippery” and cloudy, with no consensus on its meaning. In practice, ascertaining where a culture begins and ends and how to measure it may be difficult. Arguably, organizations do not constitute a single culture. For example, they may have a dominant culture reinforcing integrity as well as various subcultures promoting abhorrent behavior. The latter prove most problematic and challenging for legal compliance and risk management.
Despite these challenges, some scholars and regulators have arrived at roughly similar definitions relating culture to a set of “non-legal norms,” “conventions,” and “expectations” shared by institutional actors. (Pp. 2-6.) Even if culture is not specifically defined, and flawed cultures are unlikely to engender legal liability for directors and officers, court decisions, statutory schemes, regulations, and standard-setting organizations all signal the unquestionable importance of corporate culture acting responsibly and corporate managers setting the tone.
In conclusion, this must-read paper alerts corporate governance scholars to the haunting presence of flawed corporate cultures and provides an informative comparative assessment of how different jurisdictions address the implications.
Cite as: Omari Simmons, Responsibility for Flawed Corporate Cultures
(April 5, 2019) (reviewing Jennifer Hill, Legal Personhood and Liability for Flawed Corporate Cultures
, European Corporate Governance Institute Law Working Paper No. 413/2018 (2018), available at SSRN), https://corp.jotwell.com/responsibility-for-flawed-corporate-cultures/
Ofer Eldar & Andrew Verstein, The Enduring Distinction between Business Entities and Security Interests
, 92 S. Cal. L. Rev.
__ (forthcoming 2019), available at SSRN
While business entities have existed for centuries, their essential nature and forms of utility remain contested matters today. Over recent years, the asset partitioning theory of business entities has become highly influential, yet even for those inclined to accept it, fundamental questions remain unresolved. As Ofer Eldar and Andrew Verstein observe in the paper cited above, security interests likewise function to partition assets for the benefit of particular creditors, yet we lack a nuanced account of when one approach might be preferable to the other. In their paper, Eldar and Verstein develop a compelling foundation for such an account, analyzing these differing modes of asset partitioning and providing a fresh perspective on legal and market dynamics prompting financial innovations that, at least at first glance, appear to “blur the distinction between security interests and entities.”
Eldar and Verstein argue that, while business entities and security interests alike possess capacity to order creditors’ claims in a manner unachievable through contracts, a critical distinction remains. Whereas business entities create a “floating” priority scheme in the sense that an entity “can always update it to undermine the priority of existing creditors by pledging the assets to additional creditors,” security interests create a “fixed” priority scheme favoring “the first perfected secured interest over other claims in the assets.” This, they conclude, is why both forms of asset partitioning persist. “Security interests and entities coexist in the world and in particular structures because they offer different and irreplaceable priority schemes for creditors.”
So when might one be preferable to the other? Eldar and Verstein style the choice as a trade-off between “evaluation costs” and “managerial discretion.” The floating priority associated with business entities will generally appear preferable where one anticipates requiring “flexibility to respond to changing circumstances”—notably, capacity to continue borrowing in the future. The fixed priority associated with security interests, on the other hand, will correlatively appear preferable “when the value of managerial discretion is limited,” and “when debt liquidity is critical”—home mortgages being a straightforward example, reducing evaluation costs and facilitating a secondary market by fixing creditors’ priority.
After examining and rejecting various other potential distinctions, Eldar and Verstein deploy their floating-versus-fixed framework as a means of understanding “three areas of financial innovation” where this distinction might appear to have substantially blurred. In securitization, captive insurance, and mutual funds alike, the predominant U.S. approach involves heavy reliance on “numerous entities,” even though the asset pools are generally constructed “to ensure low evaluation costs and low managerial discretion.” Eldar and Verstein argue that, “in all these financial products, the key structural element is actually a security interest or other law that essentially fixes the priority of the creditors,” and that entities have become critical solely because, in the United States, “security interests are not bankruptcy remote.” In these fields, the proliferation of entities reflects the benefit of insulating the pooled assets they contain from the bankruptcy of a distinct management company, not the need for managerial discretion that would ordinarily render distinct entities attractive.
This insight prompts fascinating comparative points and leads Eldar and Verstein to raise important normative questions that one hopes they will continue to explore in future work. Observing, for example, that a bankruptcy-remote form of security interest under English law has facilitated a form of securitization “without meaningful use of an entity,” they reason that similar availability of a bankruptcy-remote security interest would render distinct entities largely superfluous in U.S. securitization, captive insurance, and mutual fund structures alike, eliminating substantial associated transaction costs. In this light, they further argue that the emergence of “protected cell companies” and the like—permitting more granular partitioning of assets within a single entity—reflects demand for more efficient U.S. structures combining fixed priority with bankruptcy remoteness.
“The law would be improved,” they conclude, “if it respected the bankruptcy remoteness of security interests in such contexts without requiring the interposition of an entity”—at least “where entity-based bankruptcy remoteness is already feasible.” In the meantime, Eldar and Verstein’s analysis sheds new light on a range of complex structures and highlights dynamics that will likely continue to drive financial innovation.
Cite as: Christopher M. Bruner, Asset Partitioning and Financial Innovation
(March 6, 2019) (reviewing Ofer Eldar & Andrew Verstein, The Enduring Distinction between Business Entities and Security Interests
, 92 S. Cal. L. Rev.
__ (forthcoming 2019), available at SSRN), https://corp.jotwell.com/asset-partitioning-and-financial-innovation/
Usha Rodrigues’s article on the firm as a nexus of “smart” contracts made me think of Mary Shelley’s Frankenstein. Maybe it is her use of “contracts made flesh,” the images of digital organisms mimicking their “corporeal” prototypes (creepy, if confusing), or the all-encompassing, oozing smartness of code. Victor Frankenstein was smart. He endowed his creature with formidable capacity to learn: within days, it had processed Goethe, Plutarch, and Milton. Then Victor freaked out and lost control.
Shelley’s story reads by turns as Don’t-Mess-with-Creation and Don’t-Abandon-Your-Children. I saw abandonment everywhere in Law and the Blockchain.
The article’s contribution is in carefully synthesizing contract, business organizations, and securities law as they apply to smart contracts—self-executing, self-enforcing promises encoded in digital protocols—designed to insulate private bargains from public intervention. A protocol built entirely on the blockchain would make performance automatic if pre-specified conditions are met. Borrowing an influential early image, if the vending machine gets enough change, I get a candy bar. If it rains in Spain on Tuesday, you get $20. If an investment project is certified and half the stakeholders vote to proceed as prescribed in the code, the investment goes forward. Precise thresholds and verification mechanics are central to the technology, but unimportant to the argument; let us assume that it all works as written.
Smart contracts can reduce ambiguity and opportunistic behavior in some cases, but like all contracts, they remain incomplete. Neither the parties nor the code writers can foresee all possible contingencies that might arise over the life of the contract, as smart contract aficionados recognize and as anyone who has ever kicked a vending machine can attest. Adjudication and default rules in statutory and common law would normally fill gaps in incomplete contracts. In Rodrigues’s terms, gap-filling requires legal intervention. Unless the need for intervention is encoded ex ante, a smart contract is impermeable. If an unforeseen contingency happens, the contract implodes, and takes trust in the underlying protocol down with it. One such implosion happened in 2016 and appears to have motivated much of Law and the Blockchain.
The 2016 incident involved a blockchain-based firm, or “decentralized autonomous organization” (DAO). The DAO embodies a strand of thinking in economic and corporate law scholarship that depicts the firm as “a nexus for a set of contracting relations among individual factors of production,” or a voluntary bargain hub. More exciting still, it shows how private ordering—contract plus code—could fill a big gap in the contractarian nexus that has, until now, required recourse to public ordering.
The gap arises by operation of law. Two or more flesh-and-blood people who co-own a business are, by default, a general partnership. They are personally on the hook for the firm’s liabilities, and leave the firm’s assets vulnerable to claims by their personal creditors. At the extreme, a partner’s personal creditors could seize her interest in the business, and even force its dissolution. To partition personal and firm assets, our business owners would normally have to opt into one of several legal forms, such as a corporation, that shield business assets and limit owner liability. A publicly-supplied asset partition comes at a cost, which might include administrative and governance constraints, background duties, and potential for judicial intervention. If the owners tried to achieve the same outcome by contract, they would run into coordination and moral hazard problems. For instance, each owner that contracts to shield firm assets from his personal creditors would pay more to borrow, while a free-rider who exposes the firm to his personal credit risk would pay less.
A firm that lives entirely on the blockchain can insulate its assets and protect its owners without recourse to public ordering, for as long as its flesh-and-blood owners remain hidden behind pseudonyms and its code does not contemplate distribution to, or dissolution at the behest of, outside creditors. This “nexus of smart contracts” would obviate the public-private bargain at the heart of the business form, and potentially foreclose public intervention altogether.
The firm is abandoned at birth and released into the wild, untethered from the “corporeal” business ecosystem with its legal backstops. If there is a glitch in the code that lets one stakeholder abscond with $50 million, the others have no recourse. If the code-writers decide to fleece elderly ladies under the guise of producing a Broadway show, the ladies are out of luck.
For now, the virtual economy is probably too small and fragmented to make truly autonomous, untethered firms commonplace. As long as virtual firms and their stakeholders must occasionally surface in the corporeal world, there is room for legal intervention. Moreover, as Rodrigues points out, securities regulation could create opportunities for legal intervention early in the life of a firm. If investors were to delegate firm governance to the code, regulators might recognize the investment as a security, triggering registration, disclosure, and liability rules. A single entry point for the law that is not the code should suffice to renegotiate the public-private bargain.
Frankenstein’s creature was a fascinating bundle of contradictions: beautiful and hideous, complex and primitive, yearning for humanity and bent on its destruction. Next to it, smart contracts look positively stupid. They do not brood over Man and God, but barrel along as coded, ignoring the unforeseen, immune to public interest, unmoored from social context—that is their principal virtue. Like vending machines, such stupid contracts can be very useful for their capacity to bind discrete transactional commitments. Their ability to effect asset partitioning is a different matter. The specter of runaway firms impervious to legal intervention could be a very big governance deal. Kudos to Usha Rodrigues for spotting it and launching the conversation.
In We The Corporations, constitutional law scholar Adam Winkler reaches out to the public with a sweeping account of the role and place of the corporation in the creation and ongoing evolution of the American Constitution. This is a work designed to appeal to the educated citizen at large, and Winkler uses several powerful hooks to garner the audience he seeks.
The title, of course, is an obvious hook. The first three words of the Constitution, “We the people…” is evoked, with “corporations” replacing people. This book must be about how corporations have usurped the rights of people, resulting in a union that is perfect not for the people, but for the corporations.
The book’s Introduction, visible to a potential reader browsing the electronic version of the book on Amazon, is subtitled “Are Corporations People?” Winkler immediately titillates with an account of how in 1882, Roscoe Conkling misled the Supreme Court while arguing for extending constitutional equal protection rights to his client, the Southern Pacific Railroad. Conkling had been on the Congressional committee that drafted the amendment, and he claimed not only to remember, but to have recorded in his journal, which he waived as he argued, that the Fourteenth Amendment had used the word “person” instead of “citizen” so that corporations would be included in its protections. His journal actually did not support that claim and later scholars have completely debunked it. But the seed had been planted, and the Supreme Court soon embraced Conkling’s argument that corporations have rights under the Fourteenth Amendment. “Just as I thought,” says the potential reader, “it was all a scam.”
But, of course, that is just the half of it. From the ratification of the Fourteenth Amendment in 1868 until 1912, the Supreme Court heard 312 cases dealing with corporations’ rights under that amendment but only 28 cases by African-Americans, the Amendment’s intended beneficiaries.
If you buy this book, Winkler implies, you will learn that the Hobby Lobby and Citizens United decisions are “the proverbial tip of the iceberg, the most visible manifestations of a larger, and largely hidden phenomenon”—the corporation’s civil rights movement. Buy this book, the Introduction concludes, and you will learn the “lost history of the corporate rights movement and…the dramatic, surprising, and even shocking stories behind the landmark Supreme Court cases that extended the Constitution’s most fundamental protections to corporations.”
Winkler does deliver what his introduction and title promise. But this book is much more than its reader-grabbing packaging might first suggest. This is an historical tour de force, a majestic sweeping look at America’s corporate heritage and the co-evolution of the American corporation and the American nation.
Winkler begins with the corporate nature of the American colonies, and the importance of the company charter, and corporate rights, in shaping American understanding of how to protect fundamental human rights. When America sought independence from England, it was in large measure because the Crown insisted on infringing on the colonies’ rights of self-governance guaranteed in their colonial charters. Thus, “we the people” were in many ways consciously citizens of a corporation at the outset of the nationhood.
From there Winkler systematically but colorfully describes the major constitutional law cases and debates that lead us to Citizens United and Hobby Lobby. He begins with the earliest case, Bank of the United States v. Deveaux and delves deeply into the surrounding history. We see the importance of Blackstone’s Commentaries, and the battle between Jeffersonians and Hamiltonians over the fundamental nature of the Republic. We see great lawyers plying their craft as they attempt to sway the Supreme Court. And we see the three principle positions with respects to corporate rights that persist until this day—corporations are not “persons” and should have no constitutional rights, corporations are “associations of persons” and should be able to assert the rights of their members, and corporations are separate persons whose rights should be judged without regard to the rights that its members might have had if operating as partners or sole proprietors.
Winkler then carries us through the 200 years between Deveaux and the present, recounting the back story of the important cases that collectively provide our understanding of the constitutional rights of corporations. Among many others, we meet and see the influence of Louis Brandeis, Daniel Webster, Stephen Field, Theodore Roosevelt, Charles Evans Hughes, Adolf Berle, Ralph Nader, Thurgood Marshall, Lewis Powell, Jim Bopp, David Bossie and Ted Olsen. We see how the heavy determined hands of individual justices—Stephen Field in Santa Clara County v. Southern Pacific Railroad and subsequent cases, Lewis Powell in First National Bank of Boston v. Bellotti, and Samuel Alito in Citizens United—have inserted and broadened corporate constitutional rights in ways not required to decide the case at hand.
And we learn that the root of all evil is not the Supreme Court’s treatment of corporations as “people.” As Winkler notes throughout, a Supreme Court holding that corporations are separate persons has more often been used to limit than to expand corporate rights. Indeed, Hobby Lobby is based fundamentally on ignoring the corporation as a separate person and Citizens United is grounded in the rights of the listener.
As I noted at the outset, this book has been packaged to target a broad audience of generally educated citizens. However, this is a very sophisticated and comprehensive synthesis of the work of many scholars, including that of the author. It should be of immense interest to law students and law scholars of any discipline.
But if you are a corporate law scholar, this book should be of particular interest and value. And if you are a professor of corporate law looking to offer a seminar under a title such as “Corporations, Law and Society,” this would be a great starting point. The author’s ample and wide ranging notes will jumpstart and stimulate your course planning, and this book is one which you would surely assign to your students.
Jonathan Rohr and Aaron Wright, Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets
(revised Mar. 24, 2018), available at SSRN
Every once in a while I wake up and realize that there’s a new cluster of highly technical stuff that I need to learn about to stay current in my field. My usual recourse is to find a law review article that gets me up to speed. It usually works, but not always. Back in the 1990s, for example, the leading technical topic was securitization and structured products. I read a lot of articles, but none of them got me where I knew I needed to be. Most were written by practitioners unable to get into teaching mode and present the material in an intelligible way. It took the Enron disaster to prompt the appearance of an accessible literature. Even then production was spotty, as we learned to our dismay when the economy collapsed in 2008. So, I like law review articles that teach me highly technical things that I need to know. And I really like law review articles that keep me engaged while teaching the lesson. As any business law classroom teacher knows, this is very hard to do. Complex mechanics are not easily explained, and even a successful explanation can get so wrapped up in itself as to lose the student. When an author pulls off the job in an article, the result can be a wonder to behold.
I worry that such exercises are undervalued in the present legal academic environment, for they are susceptible to snide dismissal as “inside baseball.” Such dismissals are wrong-headed. Sometimes just getting the description right and following up with a well-constructed law-to-fact analysis is vastly more valuable than any application of theoretical gloss. As Enron and the financial crisis demonstrated, the task should not be left over to practitioners. A year ago, bitcoin, blockchain, and tokens loomed up as the latest such technical topic, putting me in the market for a really good law review exposition. I found it in Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets, by Aaron Wright and the late Jonathan Rohr. The paper does three things: first, it gives its reader the tech 101; second, it confronts the big question whether blockchain-based tokens are securities under the 33 Act; third, it addresses some law reform suggestions to federal lawmakers. It succeeds beautifully at all three tasks.
The tech lesson is masterfully (and succinctly) taught. One feels as if one is encountering the techies directly as they mint, buy, and trade this stuff. It turns out that there are many variations on the basic theme of token sale. The authors get the reader through this thicket with a clear three-part typology, which they flesh out with examples of real world deals, some of which make for amazing reading. There is a big descriptive claim: blockchain tokens are to finance and investment what the internet was to information and communication; we are at a moment in history. Blockchain and the internet combine to put startups and capital together super-quickly, removing layers of frictions in one fell swoop. This reader came away convinced. Venture capital is feeling the competitive heat already. Wall Street, the City, and the world’s other financial centers are next.
The paper then turns to the “is it a security” question and a series of topics I dread—first SEC v. Howey and its progeny in the federal courts and in SEC no action letters, and then the registration exemptions, 4(a)(2), Reg D, Reg A, Rule 144A and crowdfunding. The paper maintains its level of interest as it applies tech fact to securities law, which is no mean achievement. There’s a dualism between investment token offerings (which are the functional equivalent of a sale of limited partnership interests by a venture capital firm and almost always securities) and utility token offerings (which exchange value for access to technology but also invite speculative trading and may or may not be securities depending on the facts). The latter are the problem and the paper shows convincingly that existing securities law does not offer a framework of inquiry capable of a satisfactory solution, a bad situation that gets worse when the registration exemptions are considered. Nothing quite fits, and there will be cases where exemptions make perfect sense.
The paper’s third part successfully turns to law reform. The setup is blunt: wake up and fix this you folks at the SEC or token offerings implicating registration all get done abroad, disadvantaging potential US users of technologies on offer. (The authors helpfully explain exactly how US actors can do this under US securities law and point out the jurisdictions seeking business in a regulatory race to the bottom, Switzerland and Singapore most prominently.) Yes, there’s a fraud problem, but US regulators should not let it hamstring their responsiveness. The suggestions work at two-levels. First, putting reform of statutes and regs to one side, the authors revise and restate the Howey jurisprudence into a collection of factors that will provide useful guidance in the marketplace. I am skeptical of such exercises, but came away impressed. The authors go back to the technology itself and use it to draw the line between a security and a product for consumption. The authors then propose some sensible statutory and regulatory adjustments: (1) when the token is a security, the registration requirements need to follow from an evolving practice in the token market rather than from pre-existing regulatory patterns, (2) the exemptive regs need to be tweaked, and (3) the SEC can’t look to exchanges to regulate here.
Would that there had been a paper this good when I was trying to figure out what a special purpose entity was back in the 1990s.
Cite as: Bill Bratton, Accommodating Blockchain
(October 24, 2018) (reviewing Jonathan Rohr and Aaron Wright, Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets
(revised Mar. 24, 2018), available at SSRN), https://corp.jotwell.com/accommodating-blockchain/
Horst Eidenmueller, Collateral Damage: Brexit's Negative Effects on Regulatory Competition and Legal Innovation in Private Law
(May 7, 2018), available at SSRN
The dark side of Brexit is that it illustrates dramatically the contrast between a political context which operates largely on the basis of slogans and a business and economic context where details matter. When Airbus warned of the risks to businesses if the UK crashes out of the EU without a deal, Jeremy Hunt, the Health Minister, described the intervention as inappropriate. Mark Carney, the Governor of the Bank of England, has similarly been criticised for pointing out some of the economic disadvantages associated with Brexit.
The bright side of Brexit is that it is producing some excellent scholarship in a range of disciplines as scholars try to understand its causes and potential effects. In this working paper Horst Eidenmueller argues, convincingly, that Brexit will interfere with desirable innovation in private law in Europe, both in the EU and in the UK. This is one of many examples of potential harm from Brexit to the UK and to the remaining Member States of the EU.
English lawyers like to think that English law is particularly well-adapted to dealing with new commercial problems (for example see this recent speech by Sir Geoffrey Vos, Chancellor of the High Court). English law is flexible, and English judges have tended to be pragmatic. And when English judges created uncertainties for the financial markets, as in the local authority swaps cases, other institutions have focused on promoting legal certainty. The Bank of England encouraged the formation of the Financial Law Panel to address issues of uncertainty. The current Financial Markets Law Committee continues the work the Financial Law Panel began, although it stresses its independence from the Bank of England. The creation of a Financial List as a specialist court in the UK to deal with cases involving the financial markets and with a new test case procedure “to facilitate the resolution of market issues on which there is no previous authoritative English precedent” is a recent development in this process of ensuring that English law works well for financial transactions, including international transactions.
Horst Eidenmueller argues that Brexit is likely both to reduce incentives for EU Member States to improve their own laws, and to reduce incentives for the UK to innovate. In addition, the loss of the UK’s involvement in EU law-making processes will reduce the impetus for development of EU private law. Thus, Brexit will likely “reduce the level of efficiency-enhancing legal innovation in Member States’ and European private law.”
The article supports these arguments with examples from the evolution of company law, insolvency law, and contract law and dispute resolution. Eidenmueller’s examples show in particular how competition from English law has provoked efficiency-enhancing developments in Germany. But he also notes that Germany and France have decided to enter the competition to attract business disputes to their courts, including providing for proceedings in English.
The topic of the influence of the UK on the development of EU (rather than Member State) private law is a large one, and in this article Eidenmueller focuses on some illustrative examples of the UK’s efforts to influence the development of EU law. Here the results are somewhat mixed, but in some cases (such as the Alternative Investment Fund Managers Directive) he argues that the UK did have a significant impact on the final version of EU rules (even if critics based in the UK are not entirely satisfied with the result).
The article then needs to address the significant uncertainties about the rules that will apply after Brexit. Nevertheless, Eidenmueller argues that London will be less attractive as a litigation venue, and that English law will therefore be less attractive as a governing law. And he foresees harm to the UK market for international restructurings. It is not a pretty story for the UK. But the EU stands to lose out also. If only there had been a way for David Cameron to have the opportunity to read scholarship like this before committing to the referendum decision.
Too often when discussing matters of markets and finance, policymakers and scholars lose focus of the basic fact that people are at the core of markets and finance. It is people who move markets. It is people who generate supply and demand. It is people who need financing—for homes, for investments, for education, for healthcare, and other life decisions. Behind the faceless reams and terabytes of data are people who make up the fuels and gears of the marketplace. Behind the powerful models and promising technology that frequently dominate the contemporary financial markets are people. Properly recognizing the fact that people are at the heart of markets and finance is one of the critical keys to better understanding and harnessing the power of markets and finance.
Two illuminating new books, one by a legal scholar and one by a financial economist, delve into different noteworthy aspects of the human side of markets. Professor Mehrsa Baradaran of the University of Georgia School of Law recently published The Color of Money: Black Banks and the Racial Wealth Gap, a book that examines the long-lasting effects of racism, markets, and regulation on Black communities in the United States; and Professor Andrew Lo of the Massachusetts Institute of Technology’s Sloan School of Management recently published Adaptive Markets: Financial Evolution at the Speed of Thought, a book that offers a new and more human-oriented framework for thinking about markets. Each book is distinct in their areas of focus and scope, but they both share a fundamentally human-centered perspective about the promising and perilous roles of people in market and financial decisions.
In The Color of Money, Professor Baradaran takes a historical look at the role of Black banks in connection with the economic struggles of Black communities in the United States. The book narrates the intertwined stories of Black banks and the communities that they were originally designed to serve from the time of the Emancipation Proclamation to present day. With a scholar’s talent for research and a lawyer’s power for persuasion, Baradaran makes a credible case about some of the longstanding obstacles faced by Black banks and Black communities on the road to economic success and wealth. At the start of the book, Baradaran lays out her primary argument: “Housing segregation, racism, and Jim Crow credit policies create an inescapable economic trap for black communities and their banks. Black banking has been an anemic response to racial inequality that has yielded virtually nothing in closing the wealth gap.” (P.2.)
In subsequent chapters, she bolsters her case with historical and political evidence stretching from Lincoln to Trump. She examines how politicians from both sides of the aisle, with charity and malice, frequently made it harder for Black banks and Black communities to succeed. The purpose of the book was largely to highlight the systemic and historical roots of the racial wealth gap via the lens of Black banks, and not to offer up any specific solutions to this pernicious problem. Nevertheless, by laying out the problem so thoughtfully, The Color of Money, offers a great starting point for anyone thinking about possible solutions to the persistent problems that implicate money and race.
In contrast to Professor Baradaran’s sharp and specific focus on Black banks, Professor Andrew Lo’s Adaptive Markets turns his lens on the broader topic of human behavior and financial markets by proposing what he terms as the adaptive market hypothesis. According to Lo, the hypothesis is “based on the insight that investors and financial markets behave more like biology than physics, comprising a population of living organisms competing to survive, not a collection of inanimate objects subject to the immutable laws of motion…it implies that the principles of evolution—competition, innovation, reproduction, and adaptation—are more useful for understanding the inner workings of the financial industry than the physics-like principles of rational economic analysis.” (P. 2.)
While some may expect a book focused on a new economic hypothesis to be highly technical and dry, Lo’s gift for narrative makes the distillation of his idea an easy and insightful read. Through discussions and stories that touch on the personal as well as the academic, Lo traces how he arrived at the hypothesis through twelve chapters. The book draws on a rich body of interdisciplinary research from biology, psychology, neuroscience, engineering, and computer science. Ultimately, the book argues credibly and optimistically that market mechanisms can be better leveraged to our collective social benefit when we adapt them more thoughtfully for the people involved in the marketplace.
In the end, The Color of Money and Adaptive Markets offer two deeply researched and well-told stories about two different aspects of markets and finance from two leading scholars of two distinct fields of study. Nonetheless, despite their critical differences, both books impart a common fundamental lesson about the importance of better accounting for the human factor when thinking, regulating, and acting within finance and markets. To think and act about markets and finance wholly divorced from their human participants, beneficiaries, and victims—while theoretically elegant—frequently prove to be endeavors in folly and foil with serious implications. As such, business executives, scholars, and policymakers can certainly do better to heed this shared lesson of Professor Baradaran and Professor Lo to enhance and refine the already awesome means of markets and finance towards better ends.
Cite as: Tom C.W. Lin, The Human Side of Markets
(August 13, 2018) (reviewing
Mehrsa Baradaran, The Color of Money: Black Banks and the Racial Wealth Gap
Andrew Lo, Adaptive Markets: Financial Evolution at the Speed of Thought
George S. Geis, Traceable Shares and Corporate Law
, 113 Nw. U. L. Rev. __
(forthcoming 2018), available at SSRN
Theories of corporate governance, and associated normative claims about the optimal balance of power between shareholders and boards of directors, often gloss over—or ignore entirely—”the recessed plumbing of back-end clearing processes.” To be sure, growing empirical literatures inform such debates by illuminating various strategies of exit and voice deployed by important categories of investors, yet the accuracy, efficiency, and integrity of securities trading and voting mechanisms often go unexplored. In the article Traceable Shares and Corporate Law, George Geis provides a fascinating window onto the complex mechanics of clearing and voting in publicly traded companies—and particularly how “distributed ledgers and blockchain technology” may revolutionize these processes, with potentially profound implications for corporate law and governance.
As Geis recounts, by the 1960s, transfer of physical stock certificates had become unworkable due to substantial growth in trading volume. The solution to this problem was “unidentified fungible bulk” shareholding. Shares now typically reside at the Depository Trust & Clearing Corporation (DTCC), with legal title held by a subsidiary called Cede & Company, which appears as the record holder of the stock in corporate stockholder lists. Accordingly, when the stock is sold from one investor to another, DTCC simply “transfers beneficial ownership electronically from seller to buyer via bookkeeping adjustments”—obviating the need for slow, cumbersome, and expensive transfers of physical stock certificates.
While an elegant solution in the abstract, however, the mechanics remain what Geis aptly terms “a kludge.” This results largely from the array of intermediaries—notably banks, brokerages, and third-party service providers—involved in the complex process of transmitting trading and voting information up and down the chain between DTCC, at one end, and “beneficial” shareholders, at the other. For example, the process of voting shares in a publicly traded company involves execution of a “global proxy” by Cede, the record holder, permitting votes for shares held at DTCC to be cast by custodian banks and brokerages. These in turn either execute further proxies to beneficial shareholders or (more likely) request voting instructions from them—an approach that firms may, in turn, “outsource…to a third-party provider.”
Given the complexity and the number of parties involved, it is hardly surprising that such processes could impact legal rights that hinge on identification of particular shares with particular investors. For example, § 11 of the Securities Act of 1933 provides a potent cause of action for investors who acquire shares issued pursuant to a materially misleading registration statement—but courts have tended to interpret this provision to require that the shares in question be directly traceable, with mathematical certainty, to the defective registration statement. This requirement is easily met when IPO shares represent the only publicly traded stock, yet may prove impossible to meet if multiple vintages of stock were available in the secondary market at the time of purchase—due to fungible bulk clearing. Likewise, establishing appraisal rights following a merger under § 262 of the Delaware General Corporation Law (DGCL) requires that the shares in question were not voted in favor of the merger—which could prove problematic if the complex multi-step voting mechanics described above go awry.
Against this backdrop, however, Geis argues that we find ourselves in “an important moment for corporate law…because new technology is approaching a state where clearing and settlement systems may soon support traceable shares.” Building on the detailed yet accessible technical introduction that he provides, Geis observes that “it has become possible to envision how distributed ledger technology might be adopted to permit direct and rapid settlement of stock trades.” This, he suggests, could permit development of “a ‘golden ledger’ of stockholders, reflecting the most current ownership data and substantially reducing (or perhaps even eliminating) the need for the custodial arrangements” described above.
While Geis acknowledges that any effort to develop and implement such a system would face formidable legal and technological hurdles, he concludes that “the odds of a transformation cannot be ignored” and provides a survey of the significant changes we might witness if each share of publicly traded stock could literally be traced to a particular shareholder. Straightforwardly, the action for materially misleading registration statements under § 11 of the Securities Act would become more widely available in secondary markets, as multiple vintages of stock would no longer preclude direct tracing. Identifying who should be entitled to pursue an appraisal action under DGCL § 262 would likewise become a simpler matter, as the voting record for the shares in question would be more readily determinable. More generally, we might expect “a reduction of unintentional errors,” as multiple checks on accuracy are a hallmark of blockchain technology. At the same time, such a system might curb so-called “empty voting”—that is, voting shares “without economic exposure to the consequences of a decision”—by obviating the practical need to key voting power to a “record date” falling weeks in advance of the actual vote (thereby limiting potential for voting rights to be severed from economic rights by a sale between those dates). By the same token, traceable shares might facilitate new forms of remedies—for example, permitting plaintiffs in securities class actions to “claw back” gains from investors who benefited from corporate misrepresentations (say, by selling their stock at an inflated price).
Perhaps most intriguing of all, however, are the implications for long-standing debates regarding corporate governance theory. Minimally, traceable shares could raise thorny questions “about the circumstances under which an outside shareholder (or other party) should be able to access” newly available “real time data about the identification and ownership stake of all shareholders”—access to which could readily fuel shareholder activism. At the same time, “a more accurate system for tabulating votes and parsing out other legal rights might cause some scholars to reconsider their positions” on the optimal balance of power between shareholders and boards in publicly traded companies. Where this might lead necessarily remains uncertain, given the nascent state of the technology and the fact that (by hypothesis) we cannot know what such granular data might reveal about the interests and incentives of various categories of investors. Regardless, Geis compellingly argues that traceable shares could impact corporate law and governance in fundamental ways, and the article provides a nuanced and insightful guide to this complex and dynamic landscape.