Yearly Archives: 2015

Rethinking Insider Trading Regulation

May 11, 2015 Caroline BradleyAdd a Comment

The question of distinguishing between the informational advantages insiders and outsiders may and may not legitimately exploit in trading in the financial markets is perennial: is securities regulation about achieving a level playing field for investors or about imposing sanctions for certain fiduciary and fiduciary-like breaches of duty which go beyond traditional remedies for such breaches. The Second Circuit’s decision in US v Newman emphasizes the fiduciary duty component of liability: at least in a criminal case involving tipping by insiders “the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.”

In these papers Yesha Yadav focuses on two specific problem areas in insider trading regulation, relating to trading in credit default swaps (CDS) by lenders and “structural” trading using a combination of preferential access to information and locational advantages. Both examples present arguments for a rethinking of how insider trading regulation should address the realities of modern, complex, financial markets.

The contexts of the two papers differ. With respect to Insider Trading in Derivatives Markets, Professor Yadav is addressing a context in which regulators have decided to extend insider trading prohibitions to derivative markets. In Structural Insider Trading, on the other hand, Professor Yadav identifies “cracks in regulation” (p. 4).

Congress extended the prohibition of insider trading to transactions in swaps and futures in the Dodd-Frank Act in 2010 and the CFTC implemented the prohibition in rules issued in 2011. By 2010 concerns about the risk of insider trading in credit derivatives was not exclusively a US domestic concern: the Joint Forum of transnational standard setters for financial regulation had identified this as an issue in 2008. But Professor Yadav persuasively argues that trading on insider information in CDSs may improve the informational efficiency of the securities markets, benefiting shareholders. Lenders with access to inside information about their borrowers have incentives to transfer the credit risk associated with their lending, and their ability to hedge risk encourages lending, which benefits shareholders “at least in the near term.”(p. 416) The story is not all positive, however, as lender activity with respect to CDSs may harm shareholders, and shareholders have limited capacity to monitor lenders (p. 417). Lenders may transact in ways that over-emphasize bad news (p. 419).

Professor Yadav suggests that lenders and borrowers might be able to contract around insider trading liability to fix the doctrinal problem. However, she notes that this fix might not work because corporate debtors suffer from a weak bargaining position and monitoring a lender’s compliance with the terms of a contract would be challenging. As usual in the insider trading context disclosure could play a role, although a borrower would have limited options to respond to a lender’s disclosed proposed CDS trades (p. 428). Insider CDS trading raises more general questions about the fit between established doctrine and the realities of the markets: the “tension between law and reality…dismantles long-held assumptions in theory.”

Structural Insider Trading similarly focuses on realities of the financial markets to challenge established assumptions about insider trading law. High speed algorithmic trading strategies combined with geographic proximity to trading venues provides an informational edge (p5) (of course, this development, together with the complex harmonization-differentiation picture of financial regulation also challenges some of the thinking about the decreasing relevance of geography to finance). The informational edge creates a tension between “speed in trading and the policy goal of ensuring broad and equal access to information.”(p 5) Professor Yadav argues:

structural insider trading inverts the traditional policy priority underpinning the prohibition against insider trading. Under Rule 10b-5, liability is justified as a way to protect insiders despite negative effects on market efficiency. By contrast, structural insider trading privileges market efficiency over investor protection, in giving structural insiders the ability to trade on soon-to-be public information despite costs to investors-at-large.

These are two papers which demonstrate very clearly and usefully a need to rethink one area of financial regulation for a complex, evolving, market reality.

Deterring Both Spur-of-the-Moment and Carefully Planned Corporate Crimes

Apr 13, 2015 Robert RosenAdd a Comment

How many different law review articles cite work by Kahneman and Tversky, progenitors of law and behavioral economics? At least two thousand, two hundred and seventy-three (2,273).¹ And this does not include articles like Professor Baer’s which do not cite Kahneman and Tversky, but cite law review articles which do. Law and behavioral economics is a law professor industry. And, why not? It doesn’t require math and who doesn’t like Brain Games?

How many different law review articles cite work by Oliver Williamson, progenitor of the new institutional economics? At least one thousand, two hundred and fifty-four (1,254).² Although smaller, this also reflects an industry which incorporates ideas of agency cost or of just opportunism, which Baer says is, “according to Oliver Wiliamson’s famous definition, a form of self-interest seeking with guile” (P. 99.)

What is the overlap between these 3,527 articles? That is, how many articles cite both Kahneman and Tversky and Williamson? At most 82 (2.3%).³ Of course, one might also ask what percentage of the smaller number of Williamson-citing papers cite Kahneman and Tversky, yielding a larger but still small number (6.5%). By and large, these appear to be two different lines of scholarship; two different industries.

Miriam H. Baer argues that both lines need to be considered concurrently. Why? The methods and structures of organizational compliance need to deter both deviance originating in individual departures from rationality (the law and behavioral economics line) and individuals whose rationality departs from that of the organization as an entity (the new institutional economics line). To complicate matters, in ways Professor Baer doesn’t highlight, such deterrence also sometimes cut against each other. Call it “the lure of the taboo.” Creating a culture that enshrines non-opportunistic values creates psychological pressures to evade. Sociologists talk about the normality of deviance, but you can just think of the attractiveness of shrimp to those raised in an Orthodox Jewish culture. (And let’s agree to not discuss other taboos).

Professor Baer chooses to focus on one bias, the immediacy bias (exceedingly valuing present over future rewards), which yields a short-term perspective, and temporally inconsistent actions. This bias may result in spur-of-the-moment fraud, unlike the well-planned deceptions of opportunistic individuals.

Compliance measures aimed at preventing spur-of-the moment frauds will either accelerate sanctions or delay the desired gratification. Professor Baer insightfully points out how red-tape has the positive effect of deflecting spur-of-the-moment fraud by delaying or burdening the desired gratification (P. 110.)

Professor Baer continues in this article her earlier important contribution in distinguishing between a “policing approach” to compliance and an “architectural” one (see, Miriam H. Bear, Governing Corporate Compliance, 50 B. C. L. Rev. 949 (2009). She nicely has employees involved in designing architectural constraints to their opportunism by engaging them in identifying areas of operational and compliance risk.

She very nicely describes the limits of the policing approach, which so dominates our culture, not only corporate compliance. And, she urges an integrated effort combining both approaches.

Legal scholarship, in my opinion, too often is determined by theory. Like lemmings, the legal academy follow a theory craze, hence the thousand of articles in behavioral economics and in institutionalism. Articles are written which trace out the implications of a theory for situation after situation.

Situations, however, are not determined by theory. Theory is imbricated in situations. Multiple theories need to be applied to understand, let alone control, situations. A theory might be highly illuminative (as are Williamson’s and Kahneman & Tversky’s), but that which is illuminated by a single theory will likely not suffice to guide pragmatic action. What makes Professor Baer’s article a treat is her recognition of this fact.

Human Rights for Corporate Persons?

Mar 13, 2015 David Millon1 comment

The Citizens United and Hobby Lobby decisions have drawn heavy fire from critics of the Supreme Court’s ascription of constitutional and statutory rights to corporations. According to Professor Turkuler Isiksel, a political scientist at Columbia, things may be even worse than those critics appreciate. In the paper referenced above, Isiksel illuminates and offers a trenchant critique of disturbing developments in the transnational arena that may be unknown to specialists in U.S. corporate law. Multinational corporations are claiming that, as legal persons, they are entitled to the rights of human persons under international human rights law.

These assertions seek to shield corporations from domestic regulations imposed by host countries in which they do business. Isiksel’s primary focus is the international investment regime, consisting of a large web of bilateral investment treaties and regional free trade agreements. These are designed to promote foreign investment by guaranteeing protection from expropriation and excessively costly regulations for corporations that have invested in countries that are parties to these agreements. When disputes arise between a corporation and the host state, they are typically resolved through arbitration. Arbitral tribunals are supposed to apply the terms of the particular investment agreement but “they increasingly also make use of human rights law to assess state behavior toward foreign investors.” (P. 38.) Isiksel notes that “[i]nternational human rights law is congenial to firms looking to challenge state measures because it offers a framework for contesting the treatment of private actors by states.” (P. 40.)

Arbitral tribunals have yet to declare that corporations as rights-bearing legal persons actually possess human rights. Nevertheless, these tribunals often look to international human rights law as a source for basic rights to property, due process, and access to justice, as well as principles like proportionality and least restrictive means to assess state imposed burdens. At a time when it is difficult to hold multinational corporations responsible under international law for human rights violations, there is irony in the ability of these firms to protect their own economic interests by couching their complaints against state regulation in the rhetoric of human rights. As Isiksel points out, the “moral stature” of human rights discourse is “appealing to firms looking to challenge state measures that prejudice their profit margins while claiming the moral (and legal) high ground.” (P. 40.)

Human rights claims asserted by corporations come at the expense of the political autonomy of host countries, including their power to enact regulations aimed at protecting their citizens from harm. For example, in one case a Spanish firm operated a landfill in Mexico that handled toxic substances. The facility was located a short distance from an urban center. It became the target of a local citizens’ campaign that eventually resulted in termination of the necessary operating license pursuant to a law already on the books that had previously gone unenforced. An arbitral tribunal sided with the corporation, finding that the public authorities’ response was disproportionate in relation to the asserted public health concerns and was contrary to the legitimate expectations of the corporation that the law would not be enforced against it.

While the notion of a corporation as a legal person possessing the same rights as natural persons might seem absurd, at least a first blush, Isiksel is not content with that intuition. Rather, she takes a close look at the three theories of corporate personhood that have dominated U.S. legal discourse about the nature of the corporation. These are the artificial entity, natural entity, and aggregate theories, all familiar to corporate law scholars in this country. She shows convincingly that none of these theories provides a sufficient basis for claims that a corporate person should be thought of as essentially the same as a human person or at least the moral equivalent of one. For example, she is surely right in stating that the idea of the corporation as an aggregation of humans does not imply that the corporation itself is a human being in its own right; while the constituent humans obviously enjoy human rights and those rights might be implicated by state actions taken against the corporation, it does not follow that the corporation itself somehow enjoys human rights. Beyond her effective analysis of the standard theories found in the legal literature, Isiksel does not offer an in-depth exploration of philosophically grounded ontological or metaphysical claims about what corporations are as potential grounds for human rights claims. Given the stakes, we might expect such arguments to be advanced, but whether they will gain traction remains to be seen. For now, though, Isiksel seems correct to reject the idea that sophisticated theories of corporate agency—of which there are thoughtful and persuasive instances—would also support claims of corporate humanity.

Isiksel is concerned that that the opportunistic use of human rights discourse by corporations threatens to devalue its moral stature. At the end of the day, investment arbitration cases are based on disappointed expectations of financial gain. “Claiming the mantle of human rights is therefore not only a way for firms to offload the risks of doing business to the shoulders of host states, but it also implies a non-existent human right to immunity from investment risk.” (P. 60.) Needless to say, these concerns are altogether different from basic rights to be free from torture, enslavement, arbitrary detention, religious persecution, and other kinds of suffering that can only be experienced by human beings. Might expansion of the human rights tent end up problematizing the idea that people enjoy certain freedoms simply by virtue of our shared humanity?

Isiksel ends with a provocative point that I, by no means an expert on human rights law, found quite interesting. She sees the appropriation of human rights discourse by corporations for use against the states in which they operate as based on a notion of human rights as “fundamentally supranational and anti-statist . . . located above states, making their impact on domestic politics as foreign impositions.” (P. 98.) Contrasting with this model is one that links human rights norms to local normative controversies, where norms are “developed, enriched, and transformed through domestic struggles aimed at reforming domestic public institutions, which in turn reverberate across societies and shape international instruments.” (P. 100.) According to this view, human rights norms emanate from local communities, elevating political discourse and providing standards by which states may be held accountable to their citizens. Seen in this light, efforts by multinational corporations to use human rights norms as levers against domestic regulations aimed at protecting a population’s well-being threaten the ability of local communities to elaborate and enforce human rights norms.

The deployment of human rights discourse by multinational corporations—like the claims for constitutional and statutory rights under U.S. law—are made possible by the idea of the corporation as a legal person in its own right, existing in the eyes of the law separately from the human beings who constitute it. One might attempt to ground objections to these kinds of rights claims on rejection of the idea of corporate personality, but Isiksel does not do this and she is right not to try. The corporate personality idea is too deeply entrenched in western law and legal theory to be susceptible to that strategy and, in any event, the corporation’s separate legal identity serves a socially useful function with respect to capital formation. The challenge therefore is to present strong arguments against particular assertions of rights, whether they are said to arise from international human rights law or domestic constitutions and statutes. In this paper, Isiksel succeeds admirably in exposing the weaknesses of human rights claims in an area of great importance that may not yet be well known to U.S. scholars of corporate law.

Governance by the Sword

Feb 10, 2015 Ezra MitchellAdd a Comment

Etiquette guides suggest that one has a year from the wedding to send a gift. I just read Larry Cunningham’s elegant article published precisely a year ago. So I’m on time to comment.

This piece addresses the explosion in the federal government’s use of deferred prosecution agreements (DPAs) in combatting corporate crime, a phenomenon that has increasingly become the subject of debate, at least in part because of the extraordinary fines that typically constitute a part of these deals. The corporate (or, as Larry corrects the record, partnership) death of Arthur Andersen, and enforcement in the pharmaceuticals industry (where conviction can lead to exclusion from federal health care programs to the detriment of patients) have made prosecutors sensitive to the collateral damage they can cause by indicting and trying (or obtaining guilty pleas from) corporations suspected of misconduct. Much of the literature focuses on the potential abuses inherent in the use of DPAs, which have a fitful history of prescribed guidelines and standards, and which present significant potential for prosecutorial abuse due to the one-sided nature of the bargain. (Among the abuses have been mandated—sorry, bargained-for—waivers on behalf of employees of work product and attorney-client privileges.) Further concern has been their secrecy, precluding interested corporations from tailoring compliance to address prosecutor’s concerns. While commentators see the utility of these agreements in avoiding litigation costs and achieving some measure of deterrence (in addition to avoiding collateral damage), much of the analysis has been negative.

Larry has taken a practical and sensible approach to the problem. DPAs can be useful, he tells us, but only if prosecutors approach the negotiation and structuring of an agreement as a governance problem. Ever since the 1996 Delaware Caremark decision, Delaware law at least formally has required that its corporations structure governance in a manner that discourages unlawful conduct and that makes it detectable when it occurs. Sarbanes-Oxley supplemented this approach with its own regulations. And who better to understand the governance of any particular corporation than its own board and executives? Yet, as Larry shows us, principally through his examination of the travails of AIG during the middle of the first decade of this century, prosecutors can be less than thoughtful about the appropriate, compliance-ensuring governance regime for any particular corporation. He rather convincingly demonstrates that AIG’s role in the financial crisis may well have been a direct consequence of the standardized “best practices” corporate governance regime imposed under Arthur Levitt’s supervision. (I point out that his knowledge of AIG is as a result of a book he co-authored with Hank Greenberg, who has a dog in this particular hunt, but Larry’s careful and scholarly approach give me confidence in the veracity of his reporting.)

I would do a disservice to Larry by attempting to summarize this careful and thorough piece of scholarship, so I suggest that you read it. He does an excellent job of understanding and explicating the theoretical legal place of DPAs (not quite contract, not quite regulation), as well as providing a thorough analysis of the costs and benefits of his own proposal. I will say that he left me with many questions, not least of which are the role of compensation structure, the efficacy of deterrence versus prevention, the role of punishment, and the decision to engage with the corporation rather than prosecute individual malefactors. But this, to me, is a sign that Larry has done a superb job. Indeed he has stimulated me to engage in my own research to address some of these questions. I can think of no higher praise.

Hypothesizing Regulatory Instability

Jan 7, 2015 Saule T. Omarova1 comment

Erik Gerding’s recent book, Law, Bubbles, and Financial Regulation, is an ambitious and fascinating project that seeks to explain how asset bubbles—a perennial staple of economic history—lead to and, in turn, are exacerbated by financial regulation. Gerding makes it clear from the outset that his goal is to move beyond “fixing immediate symptoms” of a financial crisis and try to uncover the fundamental factors that explain how disasters happen. To this end, he advances what he calls the Regulatory Instability Hypothesis, a conceptual framework for explaining how financial markets (traditionally, a realm of private ordering) and financial regulation (the public sphere) get locked into a deadly spiral leading to a crisis. Gerding identifies five key dynamics that define this interaction: the regulatory stimulus cycle, compliance rot, regulatory arbitrage frenzies, pro-cyclical regulation, and promoting of investment herding. His Regulatory Instability Hypothesis holds that these five distinct dynamics pose danger to financial stability by undermining laws and regulations designed to protect it.

In my opinion, one of the most interesting and novel elements of Gerding’s argument is his concept of the “regulatory stimulus cycle.” Various scholars before Gerding wrote about the multiple causes and consequences of various deregulation campaigns, including privatizations of previously public functions and repeal of specific laws viewed as constraining private markets. In the aftermath of the latest financial crisis, in particular, many were searching for specific legal mechanisms that enabled unsustainable growth in risk and leverage within the financial system in the pre-crisis decades. For example, some scholars argued that the latest crisis could be traced directly to the partial repeal of the Glass-Steagall Act in 1999 and/or the passage of the Commodity Futures Modernization Act of 2000—the two most significant deregulatory legislative acts in recent times. Others (including myself) have focused on specific regulatory or legislative actions enabling financial institutions to conduct business activities that fed the pre-crisis asset bubble.

Gerding brings together all of these strands to construct a convincing and creative explanation of the entire complex of legislative and regulatory actions and failures to act, which form a single historical pattern that cannot be reduced to a simple notion of “deregulation.” Gerding argues that asset bubbles and busts create similar cycles of “regulatory stimulus” (which encompasses “loosening” of various legal restrictions on bubble-conducive financial activities) and “regulatory backlash” (which inevitably follows an implosion of the bubble). He analyzes this phenomenon of regulatory stimulus through three theoretical lenses—public choice, behavioral economics, and social norms—and demonstrates the complexity and multiplicity of factors that create and reinforce pernicious regulatory cycles. Gerding’s argument is original, thoughtful, and quite illuminating even for those of us who are well-versed in this subject-matter.

Gerding follows a similar approach when he examines the complex factors behind the other four aspects of his Regulatory Instability Hypothesis. He continues this densely packed discussion, which forms the bulk of the book, by applying his conceptual framework to the Panic of 2007-08. Here, Gerding shows his mastery of the rise and growth of the so-called shadow banking system, which he uses as a vivid example of the bubble-bust dynamics not only in financial markets but also in financial regulation.

The last part of the book lays out the author’s vision of how to design a more effective and adaptive financial regulation that would be less vulnerable to the pernicious dynamics of regulatory instability. It’s a sweeping but thoughtful discussion of high-level principles of regulatory design that could potentially alleviate specific problems he identifies earlier. While admitting “profound challenges” of trying to counter these deeply-rooted dynamics, Gerding methodically catalogues a wide range of measures aimed at redesigning regulatory institutions, with a view toward breaking the historical pattern of boom-and-bust cycles. Necessarily lacking in specificity, this forward-looking discussion nevertheless is very impressive and effective as a conceptual framework outlining the avenues for future policy work in the area.

As with any large-scale and ambitious work, Gerding’s book may invite legitimate criticism on a variety of specific points. I do not agree with every statement, diagnosis, or recommendation for future reform that he advances in his book. I would even argue against some of his assertions (and, especially, some of his recommendations). If I were writing this book, I might have chosen a different theoretical device to construct the argument. Yet, none of these disagreements diminish the significance of the book. On the contrary, by defining the contours of the debate and creating a helpful vocabulary for discussion, Erik Gerding’s new book provides a great benefit to the scholarly community. To be sure, this book is a dense read that requires an extra effort from its readers. Yet, the result if well worth the effort.