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.
How did mail fraud come to be a powerful, all-purpose statutory tool for pursuing financial fraud in the United States? How does financial fraud resemble and differ from other kinds of commercial fraud—false advertising, misrepresenting the qualities of goods or land, or making impossible promises a seller never intends to keep? And is there, as there seems to be, a connection between novelty and innovation—new markets, new products, new frontiers—and fraud?
Ed Balleisen’s new book, Fraud: An American History from Barnum to Madoff, examines fraud, writ large in America from the end of the civil war through the turn of the millennium. As anyone who knows Balleisen’s work would expect, Fraud is exceptionally researched, observant, thoughtful, and rendered in charming prose. Fraud spans the familiar legal silos to provide a sweeping history of different varieties of fraud, and their regulation. This is useful, and the book works because of Balleisen’s disciplined focus on his core questions—how fraud manifests, how regulatory anti-fraud strategies have evolved across time, how and when industry self-regulation has intervened to control it, and how judicial institutions and processes have influenced anti-fraud efforts. The book examines a recurring toggle between interventionist and laissez-faire regulatory approaches; the venerable, if inconsistent and imperfect, tradition of industry self-regulation; and the seemingly perennial link between influence (or lack thereof), and punishment (or lack thereof). It makes a remarkable contribution to our understanding of how fraud and its regulation have evolved thus far, and the conditions out of which our current regulatory models developed.
It turns out that, in telling ways, regulation of fraud maps onto social priorities across time. Through the microcosm of fraudulent conduct and its regulation, Balleisen’s narrative exposes all the richness, promise, contradiction, and imperfection of American society and government. For example, where social status matters—as it did in the tight, homogeneous 19th century business establishment—it will matter to fraud enforcement too. One aggressive businessman with some sketchy conduct in his past will skate through to fame and fortune (see Richard W. Sears of Sears, Roebuck), while another will be ruined (see St. Louis publisher and banker Edward Gardner Lewis).
Balleisen also makes clear the abiding link between moral outrage, and core social characteristics or values. The variable forms that exhortative anti-fraud campaigns take across time tell us something about American society across time. Balleisen describes Better Business Bureau rallies in the early 20th century that were reminiscent of Protestant revival meetings; of urgings to be “a man” and therefore upstanding in the 1950s; and of claims, throughout the 20th century that fraud (or, alternatively, regulatory efforts to curb it) was “anti-American.” Predictably, more than once, such moral statements have shaded into anti-immigrant or anti-Semitic sentiment. Also predictably, though there were populist moments in which farmers or the poor were front-and-center, most anti-fraud campaigns were primarily directed toward protecting the white middle class. And yet, we should not underestimate the broader success of regulation, which inures to everyone’s benefit. I can go to the garden store to buy fertilizer, confident that it contains what it says it does. Blatant frauds like the Volkswagen emissions scandal are the exception now, at least with respect to tangible products.
One social norm is especially central, and it has dominated both opportunities for fraud and anti-fraud regulation. That is capitalism. Fraud makes clear just how thin is the line between “acceptable” capitalist pursuit of profits and “unacceptable” deceit. Particularly in boom times, capitalist enthusiasm soars and regulatory waters seem to recede. Why didn’t merit-based “blue sky” securities laws gain a more permanent foothold, for example, given how energetic the populist moment that engendered them was? Perhaps it all just seemed so burdensome during the Roaring Twenties, when everyone seemed to be getting rich quick. Balleisen also tells a series of intriguing stories about the links between novelty—new markets, new products, new frontiers—and fraud. In innovative contexts, fraud often surrounds a nugget of real promise. Novelty entails uncertainty, which blurs the line between honest, excessive optimism and outright deceit. And yet, novelty also both attracts fraudsters, and makes it harder to recognize and track their misbehavior. (Is it too obvious to mention cryptocurrencies here?)
Law has played both sides of the fostering-innovation-versus-protecting-investors dialectic. Law can be the mechanism through which fraudsters are stopped, information asymmetries are addressed, and potential victims are protected; however, law is also the means through which alleged fraudsters raise procedural complaints, claiming that state action is over-intrusive or that it violates their rights. This is not surprising: that balance is fundamental to what we mean by the Rule of Law. Still, watching those competing imperatives rise and fall across time in the context of fraud illuminates just how dependent legal practice is on its normative environment, and how implicated it is in our sometimes internally inconsistent sentiments about both capitalism and fairness. Industry self-regulation has reflected some of the same tensions: industry sometimes pressed its advantage where it could, arguing for self-regulation rather than state oversight where public sentiment seemed to allow it. And yet industry also got ahead of state regulation and implemented its own meaningful anti-fraud strategies, during times when public sentiment seemed to demand that instead.
In the end, as this history of fraud and its regulation show us, law remains a tool rather than a force unto itself. Law can occasionally change norms, but there are limits. Law-in-action finds its level, contingent on and subordinate to the dense network of norms, power and influence, and historical context in which it is embedded. If this is true, we should end with a question: what does it mean that virtually no one has been criminally prosecuted for the multiple financial frauds we have collectively endured over the last fifteen years, which Balleisen tells us are greater in magnitude and frequency than they have been at any other time in the last century?
It doesn’t take masses of data or high-powered statistics to generate important results. It takes a good question. James Coleman asks one and thoroughly massages it for insight.
Corporations exercise their speech in multiple audiences. Marketing addresses consumers. The Human Resources Department addresses employees. Coleman focuses on corporate speech to the SEC and the EPA about the proposed Renewable Fuel Standard between 2009 and 2013.
The number of corporations whose statements in the rule-making procedure and in their annual reports can be compared are small. In 2009, Professor Coleman studied 33 corporations and only 11 in 2013. The small number is not as significant as the lessons we learn when we compare what is said to these two audiences.
The messages are different. To the SEC, in their Annual Reports (10-K’s ), corporations generally minimize the impact of the proposed rule on their business. To the EPA, some holler that the rule will be unenforceable, cause them ruin and bring harm to the United States. Not a surprising result, but nicely demonstrated.
Royal Dutch Shell provides a good example. It spoke out of both sides of its mouth in 2013. It told the EPA that the Renewable Fuel Standard would “limit the supply of gasoline” and result in “severe economic harm” to its consumers and the public (at 70). In its Annual Report for 2013, Royal Dutch Shell wrote that as a result of “new energy policies in…the USA…[t]he…market for biofuels is growing…[and] We are one of the world’s largest biofuels producers” (71 n. 110).
The mention of the biofuels market is noteworthy. Regulations often will impact corporations differently. Depending on the corporations’ investment in ethanol, corporations differed in their responses to the Renewable Fuel Standard. Those invested in ethanol and biofuels sometimes urged the EPA on. Those who didn’t warned the EPA about the Standard.
The mixed messaging presents a particular problem from a new governance perspective. The new governance, unlike the old command-and-control, relies on corporate cooperation with regulation. Corporations are supposed to contribute their energies and their information constructively, both in their investor reporting and their communications with agencies. In their annual reports, corporations provide information, but more than that, they convey how their energies will be directed so that investors can make predictions about growth. These discussions of their energies should not be mere puffery. The EPA, meanwhile, needed to know whether the rules that it was proposing were feasible for regulated companies. Companies in the industry have more information than does the agency about what realistically can be demanded, but have little incentive to be forthcoming, crying about over-regulation and change for the worse.
Professor Coleman suggests that the predictions in the 10-K’s “can be used to audit corporations’ regulatory submissions “ (at 54), referencing Rule 10b-5 liability. Rule 10b-5 imposes liability for mis-statements in the 10-K, a liability that does not exist when corporations are speaking to regulators during rule-making procedures. (Of course, the PSLRA extended safe harbor protections, but did not eliminate liability for false “predictions,” as Professor Coleman emphasizes.)
I am less sanguine than is Professor Coleman about the current viability of 10b-5 litigation to keep corporations honest when they speak to regulators. But, seeking consistency when corporations speak is desirable as a matter of good governance. Much work on corporate compliance is directed to ensuring that the tone at the top is spread throughout corporate undertakings. At the least, we should, as does Professor Coleman, pay attention when corporations speak out of both sides of their mouth.
Cite as: Robert Rosen, Talking Out of Both Sides of Your Mouth
(May 18, 2018) (reviewing James W. Coleman, How Cheap is Corporate Talk:? Comparing Companies’ Comments on Regulations with Their Securities Disclosures
, 40 Harv. Envtl. L. Rev.
47 (2016), abridged in 47 ELR
16081 (August 2017)), https://corp.jotwell.com/talking-out-of-both-sides-of-your-mouth/
Elizabeth Pollman & Jordan M. Barry, Regulatory Entrepreneurship
, 90 S. Cal. L. Rev.
383 (2017), available at SSRN
Regulatory Entrepreneurship by Elizabeth Pollman and Jordan Barry provides a must-read thought provoking descriptive account of how certain companies influence and shape regulation in the modern economy. In short, “regulatory entrepreneurship” describes companies’ attempts to dismantle, weaken, and exploit gray areas in the preexisting regulatory architecture that impede a particular line of business. With clear illustrations the article sheds new light on the tactics employed by some of today’s fastest growing companies such as Uber and Airbnb to surmount regulatory obstacles.
The article distinguishes regulatory entrepreneurship (“RE”) from more reactive traditional modes of corporate political activism and lobbying where companies insulate themselves from competition and protect existing profit centers. In the traditional context, the article asserts that changing the law is not necessarily material to a company’s overarching business plan and usually constitutes a relatively small part of their overall operations and focus. By contrast “regulatory entrepreneurship” is more proactive and central to a company’s overarching business strategy and viability.
RE is best thought of as one of multiple forms of political advocacy companies utilize. Generally, companies shape and are shaped by their regulatory environments: they mobilize to alter the regulatory environment or they simply adapt to the preexisting regulatory and political context. RE reflects the former approach. It is distinct from the discussion of “regulatory arbitrage” in the corporate law literature where corporate actors merely adjust taking the “law as given, then try[ing] to take advantage of the law as best they can by making minor alterations to their behavior.” (P. 397.) RE is a process where companies proactively “seek to shape the legal environment to suit their needs instead.” (P. 397.) In practice such distinctions —RE versus regulatory arbitrage— may become blurry. Nevertheless, it is helpful to identify different methods of corporate political advocacy and possibly predict under what circumstances these different methods are likely to be successful and what types of companies are likely to use them. The article helps answer these important questions, and builds upon the literature in this area providing a more textured and contextual narrative.
Certain conditions foster RE: high profit potential; a company’s financial resources; and specific business features such as scalability, connectedness, and mass appeal. Law-related factors also contribute to the success of RE strategies. For example, certain types of regulation are more conducive to RE: regulations characterized by civil fines as opposed to criminal penalties, local and state regulations as opposed to national regulations, and unpopular regulations as opposed to popular ones. Although RE involves companies’ attempts to dismantle or weaken the existing regulatory architecture, actual repeal of regulation is not necessary for success if lax enforcement will suffice. Courts are not the most effective fora for RE; the legislative and executive branches, especially at the local and state level, are the preferred venues for regulatory entrepreneurs to exert influence.
RE is particularly popular among, but not limited to, startups and technology companies such as Uber (taxi regulations) and Airbnb (zoning regulations). Regulatory entrepreneurs tend to be well-financed-platform-oriented-start-ups, prioritizing rapid user growth over immediate profits, made possible by a large well-connected user base and an ecosystem of investors willing to support high risk growth strategies. (Pp. 430-431.) The article further suggests how an aggressive libertarian Silicon Valley start-up culture might contribute to the more aggressive tactics regulatory entrepreneurs use to bring legal change such as: breaking the law (i.e., asking for forgiveness rather than seeking permission from regulators); taking advantage of legal gray areas; mobilizing their users and stakeholders to thwart government action; and rapidly “growing too big to ban.” Pp. 398-406.)
Ultimately, the article predicts that RE will continue to grow along with the influence of regulatory entrepreneurs, due in part to regulatory entrepreneurs’ ability to mobilize large previously unorganized groups toward political action on their behalf. These developments have the potential to impact the balance of power among companies that shape local, state, and national policies in the future.
Is regulatory entrepreneurship good or bad?
The authors are noncommittal concerning whether RE results in optimal regulatory outcomes. They acknowledge that the goal of RE is profit, and there is no particular reason to expect companies engaged in RE to act in the public interest. They acknowledge RE’s benefit to the extent that existing laws or regulations may be antiquated, impede innovation, unduly restrict competition, and impose unnecessary costs on entrepreneurs, consumers, and the public. Taking a balanced approach, however, the article recognizes RE’s potential limitations. Regulations targeted by regulatory entrepreneurs, although a bit inefficient, could serve beneficial public welfare purposes that could be undermined and displaced or ignored by a regulatory entrepreneur’s narrow focus. Another important question is whether a regulatory entrepreneur’s top-down mobilization and manufacture of opposition to existing regulations reflects socially desirable outcomes or is simply another chapter in the regulatory capture story where users and consumers are manipulated as part of a broader scheme to influence the regulatory environment.
Another potential downside to RE involves expertise asymmetries between private sector companies and regulators. Regulators may not adequately study or understand the impact of new technological advances leading to suboptimal outcomes and unintended consequences. A standard critique of government bureaucracy is its slow pace responding to technological innovations. Yet delays resulting from prudent due diligence are preferable to hasty uninformed decision-making. RE is not simply a story of regulatory capture at the local, state, and national level, it may also reflect an expertise gap between government and private actors.
Is there a connection between the aggressive tactics employed by regulatory entrepreneurs, company culture, and internal controls?
The article mentions some of the criticisms and earlier scandals surrounding Uber. More recently, a high-profile scandal related to Uber’s handling of workplace sexual harassment contributed to the dismissal of Uber’s founder and CEO Travis Kalanick. Developments such as these raise questions whether companies engaging in RE are more prone to engage is overly aggressive competitive practices, dismiss widely accepted workplace norms, and have weak internal controls.
In conclusion, the article is an informative balanced assessment of a newer method of corporate political activism that will impact the shape of the regulatory environment and the balance of power among today’s companies.