Costing Financial Regulation

Nov 13, 2012 Caroline Bradley

Caroline Bradley

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

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

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

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

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

Rosenkrantz and Guildenstern Write Contracts

Sep 17, 2012 Anna Gelpern

Anna Gelpern

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

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

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

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

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

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

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

Going Public before the IPO

Jul 26, 2012 D. Gordon Smith1 comment

D. Gordon Smith

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

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

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

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

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

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

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

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

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

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

A Radical Perspective on the Mundane

Jun 7, 2012 Cristie Ford

Cristie Ford

What if it turned out that much of the crucial work that law does in the world operates in a register that is not captured by most legal scholarship? What makes legal reasoning and legal technique so resilient and so abidingly “legitimate,” even while other forms of expert knowledge, like those underpinning government fiscal policy, quantitative risk modeling, and the rational actor model unravel (as they did in the midst of the recent financial crisis)? How much of the work of building and maintaining global governance is accomplished under the radar, by the routinized practices of law – and to what extent can grand political ambition leverage these underappreciated tools in the service of its own ends? These are the challenging questions that Annelise Riles poses in this rich and elegantly-written book. For those not familiar with her argument, it merits serious attention.

The focus of Riles’s book is contracts for collateral. Riles spent years conducting field work and follow-up studies in the Japanese derivatives markets, tracking daily back office routines underlying collateral contracts. Riles argues that the legal construction of collateral is interesting for two reasons. The first is the curious fact that at the height of the recent financial crisis, when the great conceptual edifices of international finance shook, collateral – the very notion of it, its enforceability and its legitimacy – was never seriously questioned. In her words, “collateral seems to have survived the tectonic shifts in market ideologies of the last few years with its reputation intact when so much else of what once was unquestionable dogma – free markets, self-regulation, the innate brilliance and rationality of derivatives traders – now seems like a quaint mythology from a strange other world” (page 1). The book is partly devoted to trying to understand just what it is about collateral contracts that makes them so robust. She suggests, provocatively, that the wonder is not that the financial system broke down in fall 2008; the wonder is that it ever operated at all, across time zones, across differing institutional processes and national contexts, across technical glitches, and across the logistical complexities of global markets. The book is full of surprising and counterintuitive examples of the important role that legal technique plays in that system.

The second reason that collateral is interesting, as Riles demonstrates, is that collateral is precisely collateral in our thinking about law, much in the way that law itself is collateral to the sweeping political ideas that transfix us: neoliberalism, globalization, the efficient market hypothesis, global financial regulation. Collateral, and law (and the lawyers whose job it is to “paper the deals”), are sideshows, the necessary but dull operational handmaidens to the dazzling main event. Riles’s point is that in fact, the mundane technical processes surrounding collateral are sustaining, stabilizing, and even constitutive of broader governance systems to a degree that we have not appreciated. Riles says that one of the book’s goals is “to show theorists and practitioners in the law that this given and commonsense dimension of their life work is in fact doing far more work than they could possibly imagine, and that legal expertise is an ensemble of far more nuanced and fine-grained pattern of theories and practices than they acknowledge to themselves” (page 13).

As an anthropologist, Riles treats legal instruments, practices, knowledge, and techniques  – the actual filling out of forms based on the ISDA Master Agreement, the deployment of legal fictions, the particular practical problem-solving orientation underlying legal reasoning – as artifacts, and as profoundly important ones. Her account is likely to resonate with many who have experienced the way that corporate lawyers, working on a deal agreed upon by others, function almost like high priests of an elaborate follow-on legal ritual based on esoteric knowledge and arcane documents. Riles claims that legal technique matters not only in the way it might in a Deals class, or in a real deal. It also matters at the meta-level, where we think about how we might restructure a financial system to make it more robust. She speaks eloquently about the “agency” of tools, and suggests that “in the ‘meantime’ [while we are preoccupied with higher order theories and political objectives], the means often occlude the ends and overtake the instrument’s user” (page 229). Moreover, the tools Riles catalogues are specifically legal tools. For example, she describes the almost miraculous time-travelling effect that the legal fiction underlying “netting” (i.e., agreeing in advance that, at some future potential point of insolvency, collateral contracts shall be deemed prior to that point to have been netted in a particular order) has on collateral holders’ positions.

Collateral Knowledge builds a ground-up account of the profound importance of mundane legal technique, but it builds that account all the way up through the higher reaches of legal philosophy. Riles engages with Hayek, drawing on examples from risk management in the OTC derivatives markets. She rejects the Hayekian notion that public sector action is destined always to fall behind private sector action, while acknowledging the perceived “legitimacy gap” that nevertheless exists.

In a fascinating turn, she examines how the “audacious legal trick” of the legal fictions underlying collateral – which are conventionally used by private sector actors, but which are neither inherently private nor inherently public – manage to trail so much legitimacy behind them. Riles challenges the Realist notion that formal documents do not matter, and the post-Realist notion that law should be made to conform to real world conditions, on the grounds that law’s generative power derives from its own attenuated relationship to reality and its use of legal forms and legal fictions. Riles also confronts sociolegal scholarship. She challenges the distinction between law-on-the-books and law-in-action, and identifies the field’s failure to study legal discourse as a cultural phenomenon in its own right rather than just as a function of social, political, and economic forces. On each front, the book’s insistent, ethnographically-informed focus on the intricacies and function of technocratic legal knowledge practices makes a fresh and hugely important contribution.

If Riles is right, what might this mean for legal scholarship? Riles suggests that it is time to stop thinking solely in terms of grand regulatory architectures and new institutional designs, and time to examine the potential inherent in legal technique. Legal scholarship has only the most rudimentary framework for speaking about artifacts like legal forms, fictions, and routinized practices as if they were conceptually interesting or institutionally significant. Collateral Knowledge marks an important step in helping to democratize access to and appreciation of legal technique, in the service of producing more effective forms of regulation.

Making the Case for Soft Law

May 7, 2012 Bill Bratton

Bill Bratton

Every once in a while I read something and say to myself “this one’s a keeper” in the sense that it goes to the shelf to be drawn on again as an important source of knowledge.  This book earned that status early in the read and it earned it again and again as the read went on.  Indeed, I may be this book’s ideal reader for the very reason that I’m a domestic business law academic.  To be sure, the book follows from and addresses a number of international law literatures and so addresses itself in the first instance to the international legal cohort, both to international law writ large and the group’s business and financial subset.  But the learning curve is much steeper for me than for those primary addressees.  Here we find the whole cast of international financial characters–bankers, cops, securities and insurance regulators, auditors, politicians, bureaucrats, technocrats, and their international and domestic organizations–all carefully and neatly laid out with their histories, structures, and outputs juxtaposed and categorized.  My revelation lay not in the fact that I’d never heard of them (although I must admit that one or two were new to me), but in the fact that my institutional knowledge was full of holes, particularly as regards the book’s comparison to other, treaty-based international organizations.

When I picked up the book I wrote down three general observations, touchstone points to assist in evaluation.  They are:

1. Globalization implies downward regulatory pressure.
2. Soft law will always disappoint you.
3. Reputational sanctions are unreliable.

First, globalization and downward regulatory pressure.  More particularly, what’s the interface between the book’s account and regulatory competition–race to the top, race to the bottom, law as product, or whatever you want to call it?  In fact, there’s not much in the book about downward competitive pressure.  It’s more a background factor that pops up on the screen when pertinent.  Even so, I think it’s an important part of what the book is about.  I think back fifteen years or so to a discourse that posed international regulatory competition as against international regulatory co-ordination. The competition side of the binary was heavily theorized where the co-ordination side was not.  The competition side drew on economic theory going back to Tiebout and had negative things to say about co-ordination, which it cast as rent seeking.  There wasn’t a whole lot on the coordination side.  Since then international lawyers have been slowly filling in the picture.  This is where I locate the book.  For me it fills in the empty set with an exhaustive description of the international co-ordinative effort.  Theory can now start over.

Second, soft law will always disappoint you.  The book does nothing to refute this assertion, even as its author makes his enthusiasm for soft law abundantly clear.  Herein lies another source of value.  Although soft law will always disappoint, there’s no point in railing about its softness when it’s all you’re going to get.  And, says Brummer, international soft law is harder than you think.  The key lies in the capaciousness of the soft law set described.  It is not just IOSCO, or BIS and Basel.  It’s not just the G-20 plus the FSB.  It’s all of them plus the cops at the Financial Action Task Force (who appear to be pretty good at beating up on rogue states), the nasty lenders at World Bank and IMF, and the triumphant standard setters at the IASB.  The cohort, taken as a whole, held out more than enough to reckon with before 2008 and since then it has been very much in motion.  The book’s last part is a tour de force that shows the system in action, sector by sector, in the wake of the financial crisis.  No, these regulators have not solved the problem of systemic risk.  And, yes, their regulatory output very much follows from national-level initiatives.  But national level reforms are all the stronger in light of the cross-border supplement.

Third assertion: Reputational sanctions are unreliable.  This is a point I learned back in the 1980s when American management breached what the law and economics people called “implicit contracts” between corporations and constituents like labor and creditors.  Implicit meant unenforceable at law but to some extent binding in practice.  But the glue came from reputation and management overnight threw out reputational stakes built up across several decades as costs and benefits changed in a dynamic environment.  So I brought a bottomless store of skepticism to the book’s positive case for the binding impact of reputational stakes in international soft law.  I accept the book’s positive case at face value–a constraint is indeed in place.   But for me that only opens the bidding.  That said, I note that the book is unremitting in its discussion of systemic shortcomings.  Although it manifestly makes a case, it does not over-claim.

So if you know all sorts of things about international finance but the entirety remains murky for you, get yourself a copy of Chris Brummer’s book.  Pronto.

Organizational, Not transactional, Legal Engineers

Mar 9, 2012 Robert Rosen2 comments

Robert Rosen

Many are claiming that the market for legal talent is undergoing fundamental transformation.  If so, there are undoubtedly multiple causes, at the least because the legal market is a highly differentiated one.  In the individual and personal plight sector, user-friendly consumer interfaces and legislative and judicial restrictions on access to justice are of importance.  In the corporate sector, intelligent search engines, outsourcing and the internalization of legal work are of importance.

Today’s changes in the corporate sector of the legal profession, in my opinion, mirror the changes in the engineering profession at the beginning of the last century.  The basic story is that engineering was once a liberal profession, marked by engineers working in engineering firms. Now, although engineering firms still exist, by and large, engineers work inside corporations.  In this transformation, engineers, like lawyers today, lost the monopoly rents which they were able to extract in market transactions between professional firms, which largely controlled elite expertise, and corporate organizations.

To prosper, and to secure jobs for engineering graduates, engineering was forced to redefine what work within the corporation was within engineering’s jurisdiction.  To minimize conflict, the profession articulated how engineering work was to be controlled inside the corporation.  And to regain professional status, engineering graduates became general managers.

Engineering did not only play defense.  Organizational engineering emerged, most famously as espoused by Frederick Winslow Taylor, who had trained as a mechanical engineer. Later, safety engineers, product safety engineers, and security engineers, among others, became career paths within corporations and job choices for those who entered engineering school.  Playing offense, the engineering profession secured more corporate jobs for its graduates than had been available to it as a liberal profession.

Read against this background, Jennifer Arlen’s The Failure of Organizational Sentencing Guidelines, 66 U. Miami L. Rev. 321 (2012), marvelously explains why change in how lawyers serve corporations is necessary and suggests an offensive strategy.  In this article, Professor Arlen continues her earlier work demonstrating that the Organizational Sentencing Guidelines have failed to reach their goal of deterring corporate misconduct and begins to explain how organizational compliance programs can be better designed to detect, report, and respond to non-compliance.

As Professor Arlen has demonstrated previously, sanctions will not deter corporate crime, because sanctioning the organization doesn’t necessarily sanction the responsible individual and the responsible individual is difficult to detect because the organization is relatively opaque from the outside.  Instead, “corporate policing” is required.  For large corporations this creates a challenge:  How to design and implement effective compliance programs?

In this article, Professor Arlen focuses on the perverse effects of the Organizational Sentencing Guidelines on corporate policing.  The Guidelines mitigate punishment for those corporations which have adopted compliance programs.  But the guidelines fail to adequately take into account the increase in misconduct detected by these programs.  Hence, even mitigated, corporations face increased penalties as a result of their corporate policing.

Elegantly using the scoring of the Organizational Sentencing Guidelines, Arlen demonstrates that firms ought not develop compliance systems which include reporting-out if the difference between the probability of government sanction and the probability that the government detects the crime on its own is greater than 30%.  There is little doubt that there is a vast disparity between the government’s ability to threaten sanctions when the evidence is presented to it on a plate and the government’s abilities to ferret out corporate wrongdoing.

Perhaps recognizing this dilemma, in 1999, then-Deputy Attorney General Eric Holder instituted a policy of deferring sanctions (Deferred or Non-Prosecution Agreements) for the implementation of government mandates, the establishment of improved internal monitoring and increased reporting of violations.  This policy recognizes that compliance programs ex ante can reduce the likelihood of crime and ex post can uncover and sanction the responsible individuals.

Arlen applauds this policy but stresses that to be effective this policy requires the government to judge the quality of compliance programs.  But this may be beyond the government’s abilities. We know that agency costs create incentives for managers to portray ineffective compliance programs as effective ones.  And, we know that the government has failed to detect programs that are merely cosmetic.  Our inability to effectively distinguish compliance programs may have led to the inefficient result that Arlen finds:  Government unwillingness to reduce sanctions to levels that reward compliance programs.  Rather than believing that wrongdoing has come to light because the compliance program is effective, government may be as willing to believe that reported wrongdoing demonstrates that the compliance program was toothless.

Arlen suggests that not government mandates but corporate initiatives are required for the design and implementation of effective compliance programs.  At one level, compliance programs may be seen as part of a managerial or accounting task.  Arlen tells us that “directors and managers of large firms need the information and oversight that a good compliance program can provide.”  (n.69, P. 349.)  At this level of abstraction, there is no reason to believe that lawyers have anything special to contribute to compliance programs.

When Professor Arlen focuses on compliance programs, however, she does suggest how the legal profession might battle to include corporate policing within its jurisdiction. First, implementing effective compliance programs requires skills long thought to be typical of litigators, such as investigatory skills before (P. 332) and after violations. (P. 333.)  When violations are discovered, they must be reported to the authorities, with care and precision (P. 331), and then mediation and settlement activities will take place between the organization and the government. (P. 332.)  An effective compliance program also requires education about the law (P. 332) and promoting the values of legal compliance. (P. 331.)  Transactional lawyer skills are relevant for the design (engineering) of compliance programs.  Transactional lawyers are highly attentive to conflicts of interest and these conflicts within an organization often are generators of compliance violations. (P. 331.)  Transactional attorneys are well trained to spot where monitoring is required when the organization supports activities likely to generate conflicted situations. (P. 332.)

On my reading, the takeaway from this article is that government policy does and increasingly will create demand for effective corporate compliance programs and that lawyers can claim that the creation of effective programs is within their jurisdiction.  That is, legal talents are incorporated in the design and implementation of any effective compliance program.

For lawyers to provide the necessary expertise to create effective compliance programs, however, requires changes in how legal work is controlled within the corporation.  In brief, zealous advocates will not design compliance programs that effectively police corporations.  Because litigators have sold themselves as zealous advocates, their presence in the compliance process will be met by suspicion.  This is a serious challenge.  But, I began this piece noting the serious times that face the legal profession.  This is not the place to adequately address this challenge, but let me simply note again that engineering changed how engineers practicing within the corporation were controlled.

Ronald Gilson famously said that lawyers were transaction-cost engineers and thereby made the corporate pie grow larger.  Having followed engineers inside the corporation, lawyers may find themselves becoming organizational legal engineers.  Professor Arlen tells us that designing effective compliance systems will make the corporate pie grow larger.  How else can organizational legal engineers make the pie grow larger?

Professor Arlen indicates that she is now reviewing deferred prosecution agreements to uncover the variety of government mandates and compliance programs that they include.  Her research undoubtedly will uncover other skills necessary for the design and implementation of effective corporate policing. Given the needs of law students, let’s hope some of these skills are lawyerly ones. And that without their work, we can only expect The Failure of Organizational Sentencing Guidelines.

How Social Protest Infiltrates the Realm of Commercial Decision Making

Jan 27, 2012 Sharon Gilad

Sharon Gilad

The seminal socio-legal work of Neil Gunningham, Robert Kagan and Dorothy Thornton suggests that social activism is an important influence over firms’ inclination to comply with – and even exceed – regulatory environmental-protection requirements. They further acknowledge that corporations vary in their responsiveness to similar levels of societal pressure, and that the micro-mechanisms underlying this variation require further investigation. Similarly, a recent body of research in sociology and management investigates corporations’ responses to social protest. Yet, much of this literature investigates firms’ average or overall response to social protest, and not the variation among firms. The significance of Weber et al.’s article – From Street to Suits: How the Anti-Biotech Movement Affected German Pharmaceutical Companies – stems from its focus on micro-level analysis of firms’ varied response to social protest.

Weber et al.’s research investigates “how external contestation manifests itself in the internal polity of organizations” (ibid, 109). Their empirical focus is on German pharmaceutical companies’ decisions to invest in the development of biotechnology given an anti-genetic social-movement activism during the 1980s. In order to answer this question, the authors collected press coverage, various primary documents, interviews and secondary sources and produced in-depth portrayal of the social movement and of the responses of six leading German pharmaceutical companies.

Their overall findings and thesis is that the impact of social movement activism on firms’ commercial decisions is a function of the campaign intensity and its mediation by intra-corporate factors and processes. Thus, as a general rule, those firms that were targeted by successful activist mobilization – usually larger firms – were more likely to withdraw from (or to lower their pace of progression in) biogenetic projects. Yet, this overall impact was mediated by intra-organizational conflicts and identity as follows. First, the societal contestation of biotechnology rendered internal champions of the technology less decisive in their fight for their firms’ investment in new research and development due to their concern about damaging their corporate and individual reputations vis-à-vis external audiences.

Conversely, the risk that biotechnology created for firms’ reputations became a sword in the hands of executives and scientists who advocated investing in more traditional –non-biotechnology – pharmaceutical projects. In more diversified firms, which produced not only chemicals but also consumer healthcare products, those advocating investment in biotechnology projects faced particularly high competition from elites with alternative investment agendas.

Second, the social contestation of biotechnology generated uncertainty about its future regulation, and consequently reduced its projected value in comparison with alternative projects.

Third and related to the above, the internal competition within firms and the relative weight given to regulatory uncertainty was further shaped by firms’ organizational identities. Firms which viewed themselves as “core pharmaceutical producers” were more inclined to perceive biotechnology as an inevitable scientific trend, and therefore to give lower weight to societal protest and to regulatory uncertainty in their investment decisions. By comparison, firms which conceptualized themselves as a “diversified business portfolio” were more inclined to forgo investment in biotechnology in favor of alternative projects with more secure financial returns. As a result, large and diversified firms were more likely to withdraw from the biotechnology market or to move too slowly, whereas smaller firms with a core pharmaceutical identity were more inclined to successfully launch new products.

Fourth, the authors illustrate the path dependent impact of firms’ response to social protests. Rather than withdraw from the biotechnology market, some firms chose to shift their production outside Germany or to states (Landers) with less vigorous social opposition and away from their headquarters. As a result, biotechnology teams were physically distanced from the corporate centre, resulting in project coordination problems and in their weaker political position within the firm.

So what is noteworthy about the above findings and conclusions? First, their significance lies in depicting the impact of societal pressure on firms not in terms of gradual normative internalization, as typically suggested by socio-legal scholars, but as a factor that penetrates firms’ commercial investment decisions. Second, they are important in highlighting corporations’ investment decision making as a political process, wherein external societal signals are framed in light of internal struggles over alternative projects. This portrayal diverges from a common tendency to depict corporations as coherent unitary actors. Third, the article shows how corporations’ varied identities mediate their relative openness to external pressures.

Open Government and the Implementation of the Dodd-Frank Act

Dec 12, 2011 Caroline Bradley

Caroline Bradley

Much recent scholarship on financial regulatory reform since the global financial crisis critiques the substance of new standards and rules. For this paper (the draft is dated September 2011) Kimberly Krawiec chose to examine the process which produces rules of financial regulation (this is the sausage-making of the paper’s title). The current administration, like governments of other countries, has emphasized the importance of transparency and open government and of opening up decision-making to citizen participation, so an academic study like this paper, which examines citizen participation in rule-making, is timely and important.

The paper’s case study is of the Volcker rule, which restricts proprietary trading and ownership interests in hedge funds and private equity funds by banking entities. Professor Krawiec chose to focus on the Volcker rule because it “had the potential to illuminate questions of whose voice gets heard on a major issue of financial reform as the sausage is really getting made”. The Dodd-Frank Act left significant discretion to regulators with respect to the details of this rule (and others): key terms and the contours of the exceptions to the bans are not clearly defined. Professor Krawiec explains that the exceptions were a necessary component of a compromise between those who thought that Dodd-Frank should do more to rein in large financial institutions and those who were sympathetic to complaints from financial institutions. She also points out that much of the trading the Volcker rule explicitly permits shares objective characteristics with proprietary trading, such that the motive for the trading is the distinguishing characteristic.

Thus the details of the Volcker rule are being spelled out in administrative rather than legislative processes. The Dodd-Frank Act required the Financial Stability Oversight Council to study and make recommendations on implementing the rule, and in October 2010 the FSOC invited public input to the study via the Federal Register. The invitation produced numerous responses, many of which were based on a form letter produced by a coalition of public interest groups. Professor Krawiec’s study of the letters the FSOC had not identified as form letters (but many of which were) showed that 91% of the 8000 letters sent to the FSOC were form letters. She notes that the number of comment letters suggests that the Volcker rule has some public salience, although the use of the form letter “does not require the same level of investment as the detailed, heavily researched comments submitted by financial institutions and trade groups”. (P. 21.) The comment letters written by private individuals contrast sharply with those submitted by financial institutions and trade groups. Those which were not based on the form letter were short and tended to

lack specific suggestions or recommendations for interpreting and implementing the Volcker Rule… contain many grammatical, punctuation and typographical errors, and express extreme anger at the banks and, often, at the political system as well. (P. 22.)

One result of the governmental insistence on transparency is that the federal financial regulators (including the Federal Reserve Board) have been disclosing information about their communications with the public, including meetings. Professor Krawiec studied available information about meetings between federal regulators and financial institutions, law firms, trade associations and lobbyists and public interest groups. She writes:

In sum, whereas financial industry representatives met with federal agencies on the Volcker Rule a total of 265 times, meetings with entities or groups that might reasonably be expected to act as a counterweight to industry representatives in terms of the information provided and the types of interpretations pressed… numbered only 18. This is roughly the same number of times that a single financial institution–JP Morgan Chase–met with federal agencies on Volcker Rule interpretation and implementation. (P. 27.)

Moreover, nearly all of the small number of meetings between the federal agencies and  public interest and advocacy organizations were group meetings.

In the concluding section of the paper Professor Krawiec is careful not to make dramatic claims about what impact the submissions and meetings had on the development of the regulatory agencies’ thinking about how to draft regulations to implement the Volcker Rule. But the paper raises some important questions about how transparent rule-making processes really are, even in the era of open government.  Proposed Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds (127 pages of them) were published in the Federal Register on November 7, 2011. The proposing release refers to the FSOC study and states that:

Approximately 8,000 comments were received from the public, including from members of Congress, trade associations, individual banking entities, consumer groups, and individuals. As noted in the issuing release for the Council Study, these comments were carefully considered by the Council when drafting the Council study. (P. 3.)

This brief statement gives a very different picture of the comments from the one portrayed in Professor Krawiec’s paper.

Into the Heart of Darkness

Oct 21, 2011 Bill Bratton1 comment

Bill Bratton

The GW Center for Law, Economics & Finance, under the leadership of the redoubtable Lisa Fairfax, last spring held its first Junior Faculty Business and Financial Law Workshop. I was one of the old fogies called in to do commentary. It was a successful event. The papers were strong and I was glad of the opportunity to acquaint myself with their authors.

One of the papers has loomed particularly large in the memory—From Graham-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, by Professor Saule T. Omarova of North Carolina Law.

You can see from the title that to take up this paper is to journey into the darkest jungles of banking regulation. Prior to 2008 this was a subject matter of which I was blissfully ignorant. Since then it’s been a forced march through the law and economics of systemic risk and safety and soundness. (I now regularly check into the websites of the Federal Reserve and the Bank for International Settlements.) But, still not having been asked to teach the banking course, I remain hazy on many regulatory nuts and bolts.

That’s where this paper comes in. Professor Omarova takes a sustained look at section 23A of the Federal Reserve Act, a piece of Depression-era legislation that regulates financial relationships between banks and affiliates within holding company structures. The idea is to make sure that the bank, with its deposit insurance subsidy, does not in turn subsidize risky business undertaken elsewhere in the holding company. Section 23A, as originally enacted, worked in tandem with the Glass-Steagall prohibition on investment banking by banks. The paper shows how the section’s operation changed materially when Graham-Leach-Bliley dismantled the wall of separation, and changed again in the wake of the financial crisis.

The operator is the Federal Reserve and the modus operandi is exemption from the section’s operation at the application of a regulated bank. Professor Omarova takes us through decades of Federal Reserve exemption orders. It is amazing stuff. For example, we see Citibank go the well repeatedly. It acquired little nonbanks that churned out subprime mortgages and then, claiming administrative cost savings, subsumed them into the bank (and its subsidy) with the Fed’s blessing. Starting in 2007, as the Fed tore up its own rulebook to spread liquidity, it granted section 23A exemptions of enormous magnitude. Finally, with Dodd-Frank the Congress amended the section, extending its reach.

It is all very complicated, but Professor Omarova makes it intelligible. The journey proves well worth the effort. The author is to be congratulated for digging up the details on this crucial zone of administrative practice and holding the results out for public inspection. The faults are laid bare for all to see. But Professor Omarova is much too astute to cast easy stones. We are told to take the occasion to rethink the whole, asking ourselves what we want out of banking regulation. Unfortunately, as we work our way to that sensible conclusion, we see that the occasion was not taken in the run up to Dodd-Frank.

Vision and Loss

Sep 23, 2011 Anna Gelpern

Anna Gelpern

It is so very lucky that Sarah Woo chose to write Regulatory Bankruptcy: How Bank Regulation Causes Firesales as one article, not the four it could have been. When she died this summer, the legal academy lost a truly original thinker and careful researcher who asked the right questions—and had the knowledge, insight, and judgment to answer them. It is a huge loss.

Regulatory Bankruptcy is the rare article that finds smart answers to interesting questions, which also happen to be good answers to very important questions. The project occupies the intersection of bankruptcy, financial regulation, risk management, and crisis response, and makes theoretical and empirical contributions to each of these fields. I especially appreciate the way in which it helps flesh out the under-studied relationship between law and macroeconomic policy.

The article’s core argument goes to bankruptcy theory: the assumption that creditors seek to maximize individual asset recovery values in bankruptcy cases. Over the years, bankruptcy theorists have argued bitterly over the prescriptive implications of the maximizing assumption—whether it is socially desirable—but barely over the description. More recently, scholars have chipped away at the edges of the description, for example, where securitization or credit derivatives alter creditor incentives.

Woo’s case study goes to the heart of the bankruptcy paradigm: mid-market banks making simple secured loans for commercial real estate development. Her theoretical model suggests that banks, which manage risk on a portfolio basis, may suffer higher losses from asset concentration than from deterioration of individual assets. In their push to reduce concentration (or the proportion of commercial real estate loans in their portfolio), banks will rush to liquidate collateral, such as half-built homes, which would fetch far more if completed. This effect is especially pronounced in an economic downturn, and exacerbated by bank regulation and supervision.

For banking scholars, such findings are only partly intuitive. When bank supervisors press their charges to boost capital adequacy ratios, banks can either raise capital in the numerator, or sell assets in the denominator. The choice between categories and within each category is influenced by regulation and market conditions. For example, if regulators define qualifying capital narrowly, and it is relatively expensive to issue, banks will try to shed assets—especially those that carry high regulatory capital charges, come with supervisory penalties, and can fetch more in the market. In this world, it is perfectly plausible that a bank would choose to sell a “good” asset that has a high regulatory cost.

In Woo’s findings, regulation amplifies the risk management effect. Banks already benefit from reducing portfolio concentration; they benefit even more by responding to supervisory pressure to diversify. A key new twist comes with an economic downturn or a policy change: either or both can create across-the-board pressure on banks to sell assets, leading to fire sales and further depressing prices (bankruptcy contagion). Woo’s addition to financial regulatory literature thus is a mirror image of her bankruptcy contribution: in bankruptcy, she shifts focus from the debtor to creditors as a group; in banking, she illuminates the effects of regulatory policy on debtors as a group, and on other creditors.

If the core argument of the article is innovative, Woo’s execution is especially impressive. She develops her basic model by simulating loss rates in hypothetical bank portfolios with different levels of concentration in real estate construction and development. She finds that under stressed conditions concentration risk could become even more important than individual loan quality in driving portfolio losses, owing to loss correlation. Put differently, a bank with a decent but concentrated real estate portfolio may well lose more in a recession than a bank that made lower-quality real estate loans, but diversified better across sectors. The article proceeds to document a regulatory policy shift beginning in 2006 which resulted in across-the-board pressure on U.S. financial institutions to diversify real estate risk.

The empirical heart of the project is Woo’s analysis of data from real estate developer bankruptcies, combined with FDIC/FFIEC data on portfolio concentration and capital adequacy of the developers’ bank creditors. The hypothesis is that banks with higher real estate concentration ratios are more likely to ask bankruptcy courts to lift the automatic stay, allowing the banks to sell the underlying collateral (unfinished developments). To this un-quant, the analysis suggests pretty persuasively that concentration ratio trumps many other factors in driving bankruptcy fire sales.

The article ends with specific and sensible policy recommendations for bankruptcy reform and systemic risk regulation. More importantly, it helps inform bank regulators of bankruptcy, and bankruptcy judges of bank (and regulator) incentives, with implications far beyond the immediate context of the real estate case study. Woo is remarkably in tune with the latest economics research on crises and macroprudential regulation, yet she goes further to show that legal scholarship–as in her rich account of bankruptcy and banking law in action–has much to teach economists in this area.  Her careful tracing of the ways in which “micro prudence” on the part of individual institutions, risk managers, judges, and regulators can become “macro risk” for the economy is smart, interesting, right, and immensely valuable.

Sarah Woo only just began teaching at NYU last year.  She leaves behind an amazing range of articles, from contracts and project finance to bankruptcy, rating agencies and systemic risk regulation, along with blog and Jotwell contributions. Few people could or would take on the challenges she chose.

I met Sarah once last January, when she presented a version of Regulatory Bankruptcy and commented on other panelists’ papers—except that her commentary came complete with original (“quick and dirty”) data and graphs, which left both beneficiaries and observers momentarily speechless. I have kept her PowerPoint on my desktop, to remind myself of the effort and generosity we owe our colleagues and our audiences.