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This Is Not Your Parents “Market Efficiency” . . .

Dan Awrey, The Mechanisms of Derivatives Market Efficiency, 91 N.Y.U. L. Rev. 1104 (2016).

“Market efficiency” is one of the most widely used, and frequently over-used, concepts in modern financial economics and its cross-disciplinary offspring, law and economics. Every student taking corporate finance or securities regulation knows about the Efficient Market Hypothesis. Every policy proposal must grapple with the issue of how it would impact the relevant market’s “efficiency.” And, of course, innumerable law review articles employ the vocabulary of “market efficiency” to support a variety of doctrinal, empirical, and normative claims. Yet, this theoretically elegant concept often seems to be a rather imperfect representation of what actually happens in real-life financial markets. The latest financial crisis made this problem simply impossible to ignore. Of course, a sensible way to bridge the gap between theory and practice is to refine or revise the theory, so that it provides a better explanation of the relevant reality. That’s easier said than done, however. Not surprisingly, the post-crisis explosion of academic writings on financial markets and regulation has produced disappointingly little by way of true theoretical advancement, at least so far.

Dan Awrey’s new article, The Mechanisms of Derivatives Market Efficiency, is one of the few rare exceptions in that respect. It is cleverly framed as an attempt to update and extend the theoretical framework originally laid out by Ron Gilson and Reinier Kraakman in their canonical 1984 article, The Mechanisms of Market Efficiency. Gilson and Kraakman were the first to identify and map out the key channels through which any particular piece of new information, depending on the cost of acquiring and processing it, gets incorporated into the publicly-traded stock prices. Among other things, they explained how numerous professional traders (broker-dealers, research analysts, investment managers, etc.) obtain, process, and disseminate costly private information, thus collectively enabling stock market prices to move to the new optimal levels.

Since its publication in 1984, Gilson and Kraakman’s article has been enormously influential in shaping both the dominant understanding of how capital markets operate and the mainstream debates on how they should be regulated. Ironically, however, the 1990s already marked the beginning of a qualitatively new era in modern finance. The rise of over-the-counter (OTC) derivatives trading, in particular, has been a true game-changer for the structure and operation of global financial markets. As Awrey points out, OTC derivatives markets are fundamentally different from the traditional highly regulated, order-driven, and deeply liquid markets for publicly-traded securities. And, insofar as Gilson and Kraakman’s theory was developed in the context of the traditional stock market, it does not offer a satisfactory explanation of how derivatives markets manage the challenge of informational efficiency.

Awrey begins his project of extending their theory beyond its limited original context by spelling out how derivatives contracts differ from publicly-traded stocks. As executory contracts performed over time, derivatives necessarily involve idiosyncratic counterparty credit risk. Derivatives markets lack the benefits of transparency and liquidity provided by the organized and regulated stock exchanges. Instead, derivatives markets are organized around a small network of large financial institutions—the “dealers”—that run huge portfolios of client trades and quote bid and ask prices to one another. These key features of derivatives explain the existence of potentially severe informational problems in these markets, such as the extremely high costs associated with finding derivatives counterparties, monitoring their performance, and properly pricing bespoke instruments.

Furthermore, as Awrey argues, even where traders can see actual prices of derivatives trades, they are generally unable to “decode” the relevant economic information in Gilson and Kraakman’s sense. This is a result of the high contractual malleability and heterogeneity of derivatives contracts. Because the cost of trading with a particular counterparty depends on many trade-specific factors (the counterparty’s creditworthiness, the terms of the contract, the amount and quality of collateral, the overall economic relationship with the same counterparty, etc.), the stated price of the contract does not fully reflect its de facto economic price. Awrey quite brilliantly depicts this phenomenon as an iceberg, where the stated contract price is only its visible tip (the “bright side” of a derivative contract) while the rest of the economically relevant contractual terms are hidden from view (the “dark side” of a derivative contract).

Building on this insight, Awrey identifies four principal mechanisms of informational efficiency in derivatives markets. The first mechanism is the network of derivatives dealers at the center of derivatives markets who, by virtue of their market-making function, produce and disseminate critically important information. The second mechanism is the supporting network of inter-dealer brokers and electronic trading platforms, which facilitate exchange of information among dealers. The third mechanism is the highly specialized and interlinked contractual and legislative regimes that govern enforceability and operation of critical contractual arrangements, such as close-outs and the treatment of collateral in the event of a counterparty bankruptcy. The final mechanism is the global market-wide standardization of derivatives contracts, mainly through the efforts of the International Swaps and Derivatives Association. Awrey’s article explains how these four mechanisms interact to enable derivatives markets to overcome informational challenges posed by the “dark side” of derivatives. Although very different from Gilson and Kraakman’s archetypal forms of informed or uninformed trading in public stock markets, these institutional arrangements are what ultimately enable the flow of otherwise prohibitively costly and largely unusable trade information in derivatives markets.

Identifying and examining these four mechanisms of derivatives market efficiency allows Awrey to assess the efficacy of various post-crisis regulatory reforms, including mandatory systems of pre-trade and post-trade reporting, new prudential regulation of derivatives dealers, and the shift to centralized derivatives trading and clearing. Awrey’s most intriguing and far-reaching normative conclusion, however, goes beyond these familiar measures and envisions central banks taking a more active role as the “ideal market-makers” uniquely positioned to ensure the necessary liquidity and informational efficiency of derivatives markets. My big hope is that he expands on this idea, which is near and dear to this reviewer’s heart, in future work.

There are many reasons to like Dan Awrey’s article. He has a genuinely deep practical understanding of derivatives markets, which does not come from simply “reading up” on the subject for purposes of writing an article. The article is superbly framed and executed: the scope of the inquiry is well-defined, the theoretical “hook” is extremely effective, and the argument is laid out clearly and convincingly (and without unnecessary over-claiming). Even a derivatives expert will learn a lot from reading this piece. What makes this article especially noteworthy, however, is that it offers an intellectually inspiring deep rethink of one of the core concepts in mainstream financial economics. In that sense, Awrey’s update of the theory of “market efficiency” is very much in line with other recent law-and-finance scholarship that seeks to deconstruct and demystify such fundamental theoretical and policy-shaping concepts as “financial intermediation” and “safe assets.” I excitedly look forward to our collective next step on this path toward a better—more accurate and empowering—understanding of modern finance.

Cite as: Saule T. Omarova, This Is Not Your Parents “Market Efficiency” . . ., JOTWELL (January 25, 2017) (reviewing Dan Awrey, The Mechanisms of Derivatives Market Efficiency, 91 N.Y.U. L. Rev. 1104 (2016)),

An Unsafe Financial System

Anat R. Admati, It Takes a Village to Maintain a Dangerous Financial System in Just Financial Markets? Finance in a Just Society (Lisa Herzog ed., forthcoming 2017), available at SSRN.

It Takes a Village to Maintain a Dangerous Financial System, a chapter by Anat Admati in a forthcoming book should be required reading for legislative actors who are thinking about reviewing rules of financial regulation introduced after the onset of the global financial crisis.

Before the global financial crisis, policy-makers believed in risk-free assets and risk mitigation techniques. The Basel Committee on Banking Supervision developed capital adequacy standards to identify and neutralize a range of risks associated with the business of banking. But the crisis revealed weaknesses in the standards, and in their divergent and inadequate implementation, as well as new risks that the standards did not address. At the same time, as Andrew Haldane, Chief Economist at the Bank of England, has acknowledged, “the economic and financial crisis … spawned a crisis in the economics and finance profession.” In responding to the financial crisis, the G20, the Basel Committee on Banking Supervision, the Financial Stability Board, and the IMF announced a new commitment to focus on improving international standards for bank regulation and to ensure that the standards were implemented effectively. Regular reports by these bodies note concerns relating to financial stability, but suggest that they are making progress in achieving the agreed objectives for financial, and particularly bank, regulation.

The official, rather sanguine, view that financial regulation is becoming more effective faces challenges from two perspectives: that of financial firms and others who argue that regulatory burdens are too onerous and are reducing access to credit, and that of critics who argue that the post-crisis regulatory changes do not go nearly far enough. Jeb Hensarling, the Chairman of the House Financial Services Committee has proposed The Financial Choice Act to undo some of the effects of the Dodd-Frank Act. The EU Commission acknowledged in November 2016 after reviewing responses to a call for evidence on the EU regulatory framework for financial services that “targeted follow-up action is required in … reducing unnecessary regulatory constraints on financing the economy; enhancing the proportionality of rules without compromising prudential objectives; reducing undue regulatory burdens; making rules more consistent and forward-looking.” These developments imply something of a slide back to pre-crisis thinking.

But we may never really have moved beyond this pre-crisis mindset in any real sense despite the crisis, as Anat Admati’s chapter argues. The chapter builds on previous work, but is shorter than The Bankers New Clothes, her co-authored book with Martin Hellwig, and is an elegantly written and beautifully constructed piece which explains financial regulation as flawed due to the work of a range of “enablers.” The “enablers work within many organizations, including auditors and rating agencies, lobbying and consulting firms, regulatory and government bodies, central banks, academia and the media.” Part of the problem Admati identifies is the familiar issue of revolving doors recently illustrated by the decision of José Manuel Barroso, former President of the EU Commission, to work for Goldman Sachs. Admati writes that revolving doors “contribute to excessive complexity of regulation, because complexity provides an advantage—and creates job opportunities—to those familiar with the details of the rules and the regulatory process. Complexity also opens more ways to obscure the flaws of the regulations from the public and create the pretense of action even if the regulations are ineffective.”

This issue of regulatory complexity is an important one. But regulatory complexity can be used as an argument in different ways. In the chapter, Admati warns that the problem that expertise is constructed in ways that exclude critical and outsider views is still with us post-crisis, and she discusses the impact of spin and particular narratives on financial regulation (for example, showing how writing about capital is often misleading, and how bankers invoke the specter of “unintended consequences.”) We can see this sort of use of spin and narrative in the Hensarling Financial Choice proposal. The proposal is supported by a “comprehensive outline” which applies a complexity critique to Dodd-Frank, explicitly relying on Andrew Haldane’s Dog and the Frisbee speech (which the comprehensive outline refers to as having “achieved notoriety among financial regulators and scholars). But the proposed unravelling of much of Dodd-Frank would still leave in place much of the complexity of financial regulation in the US.

Admati’s chapter begins with a powerful comparison of safety in banking and aviation. Admati argues that whereas all of the actors in aviation safety have incentives to ensure safety this is not the case with respect to banking where “banks effectively compete to endanger.” The chapter ends with an injunction:

Entrenched and powerful systems resist change, but a just society must not tolerate a situation in which critically important systems like the financial system are run against the interests of the vast majority. More people must become aware of the problem and understand what is wrong. Then they must demand that policymakers do better.

Cite as: Caroline Bradley, An Unsafe Financial System, JOTWELL (December 6, 2016) (reviewing Anat R. Admati, It Takes a Village to Maintain a Dangerous Financial System in Just Financial Markets? Finance in a Just Society (Lisa Herzog ed., forthcoming 2017), available at SSRN),

Corporate Dystopia

Sometimes reading a book about one’s own field can be a painful experience, not because there’s anything wrong with the book, but because the book is so instructive and insightful as to highlight one’s own shortcomings of knowledge and understanding. I had this bittersweet experience with Jerry Davis’ The Vanishing American Corporation.

The vanishing corporation in question is the big, publicly-traded manufacturer that dominated both economy and society from the end of World War II through the 1970s. Since 1980, this kind of company has been disappearing, relatively speaking. But we knew that, didn’t we? Sure, what with restructuring and downsizing, our awareness is keen. But I’m not sure we have appreciated the extent of the change and grasped its implications. That’s where Jerry Davis comes in. Davis, who is on the both the business and sociology faculties at Michigan, brings the perspectives of both disciplines to bear as he takes a broad view of the evolving role that corporations play in society. The presentation is also historical, as makes sense for an account that asks us to compare what we have now with what we have lost. The book takes us from post-war managerialism and a world where the big corporation is far and away the dominant employer, to the economic crisis of the 1970s and eroding confidence in American managers, to the leveraged restructuring of the 1980s, and finally to the tech-centered present. The focus is on employment, welfare provision, and the corporation’s social presence in tandem with an account of the evolution of shareholder-manager relations and corporate governance. The big corporation starts to shrink after 1980 and keeps on doing so. This starts with a big bang: the conglomerate bust up of the 1980s, and with it, the end of life-time career tracks and narrow salary dispersions within corporate hierarchies. Thereafter, between competition abroad and shareholder value maximization at home, the process continues more quietly but just as determinedly. Gradually, corporate institutions give up (or, in some cases, default on) the responsibilities for social welfare provision they assumed in the years after World War II. Today, a company centered in a national economy in which welfare provision was remitted to the state in the years following World War II is ceteris paribus a fitter competitor than a US company saddled with the burden of providing medical benefits for its employees. Meanwhile, what were once corporate careers have evolved into temporary corporate jobs, and not all that many of them, particularly in the tech sector. Future generations may not get corporate jobs at all, instead performing piecework tasks distributed through internet clearinghouses.

For this corporate law academic, Davis’ account comes as a needed corrective. We have spent a quarter century in the field worrying about excess management power and agency costs against a policy template that depicts shareholders as a legally disabled class holding a species of permanent regulatory entitlement. In Davis’ view of the world, the decisive phase of the struggle between managers and shareholders ended before 1990. It was all over but the shouting once managers internalized shareholder value maximization as the appropriate corporate goal and turned it to their own advantage by revamping compensation systems, with the losers being the vast class of employees lacking capital endowments. Where once industrial organization posed a continuing question of “make or buy,” now there was a clear, simple answer: “buy,” and buy from wherever labor is cheapest. And don’t worry too much about your purchase’s more particular origin abroad, at least so-long as dirty facts don’t get out and catch the public eye.

One ends up wondering what the future holds for our students. Davis does too, offering two scenarios, one bleak and the other optimistic, the optimistic one focused on a new localism facilitated by technological advance. Unfortunately, the optimistic projection, while spirited, is also highly imaginative and does not outweigh the bleak one in the mind of the reader.

Summing up, this is a splendid, holistic view of recent corporate history, stated for the most part as a succession of fact. The prose is clear and lively. The narrative line is strong, and fleshed out with telling anecdotes and impressive statistical showings and comparisons. The voice is passionate, but resolutely and consistently reasonable. I warmly commend The Vanishing American Corporation for a stark and instructive perspective on a story with which we are all familiar.

Cite as: Bill Bratton, Corporate Dystopia, JOTWELL (November 7, 2016) (reviewing Gerald F. Davis, The Vanishing American Corporation: Navigating the Hazards of a New Economy (2016)),

Friends Don’t Let Friends Trade on Inside Information

Sarah Baumgartel, Privileging Professional Insider Trading, Ga. L. Rev. (forthcoming 2016), available at SSRN.

Just when you thought it was safe to avoid yet another article on insider trading comes Sarah Baumgartel’s imaginative and insightful paper. Baumgartel’s point of entry is several recent and pending cases that in some ways extend, and in other ways limit, the peculiar misappropriation theory, a judicial development that continues to prove not only that bad cases make bad law but that they also can make for good scholarship.

Before I get into a few of the details, here’s the bottom line: The misappropriation theory, and especially the Commission’s redaction of “confidential relationship” in Rule 10b5-2, are yet another example of facilitating the economic inequality that has achieved such prominence in contemporary discourse. Baumgartel doesn’t quite put it this way, but she does argue that the manner in which the misappropriation theory has come to impose liability on traders who received their information in the context of personal and often intimate relationships while providing exculpation for professionals and managers who trade on that information satisfies neither the information-protective function of modern insider trading law nor the market fairness rationale that often is invoked. Instead, it sends your golf buddy or your sister to jail while allowing business professionals to reap harvests from fields that ordinary people can’t even locate.

Baumgartel briefly suggests that insider trading law is the result of powerful interests protecting their rents, and this certainly is plausible. She also sees the expansion of insider trading law from professional relationships to personal relationships as a “jurisdictional hook” on which to hang liability for nothing more than personal ethical misconduct, a trend that she situates in other areas of the law.

She also asks that we bid goodbye to the market fairness rationale for insider trading prohibitions. How can it be fair to let professionals benefit from insider trading while precluding market participants whose only hope of getting access to that type of information is the mere dumb luck of personal relationships? She even suggests that fairness, as developed in this context, is an irrational concept. Questioning what fairness means in this context, she reduces it to “nothing more than getting information the owner did not authorize you to have.” Even a cursory reading of the quoted material shows that the word “fairness” has no serious meaning here.

Ultimately, insider trading law is about securing one’s right to protect and use one’s confidential information as one sees fit. Fairness has nothing to do with it, nor does any other market regulatory purpose. It really is a branch of property law (along with the personal ethical regulation mentioned above).

All of this is woven through a doctrinal examination of case law and regulation and, to this reader, provides an example of what really good doctrinal work looks like. Baumgartel amasses the evidence, analyzes it closely, and then steps back and asks: Why does all this matter? While legal change, even if incremental, could result from such work, Baumgartel helps us to see the big picture of what actually is transpiring beneath the details. By doing so, she fits her subject nicely into contemporary social narratives and political debates and unveils rather prosaic material as part of a much bigger (and troubling) trend.

There are a lot of ideas here. Baumgartel has much to say but not much room in which to say it. I get the sense that there are at least several papers waiting to be generated from this one. And I look forward to seeing them all. This is an excellent paper in its own right, but it also reveals the potential its author has for important future work.

Cite as: Ezra Mitchell, Friends Don’t Let Friends Trade on Inside Information, JOTWELL (October 7, 2016) (reviewing Sarah Baumgartel, Privileging Professional Insider Trading, Ga. L. Rev. (forthcoming 2016), available at SSRN),

See. Spot. Catch. Frisbee. (… or Behold the Simple Elegance of Bank Capital, Upside-Down)

Heidi Mandanis Schooner, Top-Down Bank Capital Regulation, 55 Washburn L.J. 327 (2016).

In the words of one younger and wiser colleague, “prescriptions are empty calories for law review editors.”1 Many fabulous articles uncover new histories, new facts, new frames … only to fizzle around the obligatory Part V, with its half-hearted defense of a model law or regulatory gimmick, that orphan child born of perfunctory comments in faculty workshops.

The latest article by Heidi Mandanis Schooner, based on her endowed lecture at Washburn Law School, is a rare counterexample—a stunningly simple reform idea that would literally upend the paradigm of bank capital adequacy, dispensing with some of today’s most urgent and intractable financial regulatory debates. The Washburn Law Journal symposium issue (which includes insightful commentary on Schooner’s lecture) and her spinoff testimony before the Senate Banking Committee are rich food for legal, economic, and policy thought—but are not very well-packaged, and could easily get lost in the buzz and dazzle of the fast-growing scholarly field.

Here are the problem and the fix, in a nutshell.

Under the existing regime, banks and a growing set of other financial firms must keep a minimum cushion of regulatory capital (roughly meaning equity and certain junior liabilities) to absorb losses in the event their assets decline in value. If its cushion is too small, a firm might fail, depositors and other senior creditors might lose money, and other firms and markets might succumb to contagion. To prevent or contain a financial crisis, the state might step in with a bailout.

The proper size of the capital cushion is the subject of a huge, nasty, and mostly unresolved academic and policy debate, which Schooner recounts briefly in her piece. The “consensus” range is somewhere between 4 percent and 40 percent, reflecting different methodologies and normative perspectives. In practice, the floor has been set by international agreement: since the late 1980s, the successive Basel Accords have articulated global norms for bank capital adequacy, and ever more convoluted ways of measuring it. Basel I, II, and III reflect technocratic and political accommodation among regulators who oversee the world’s largest financial institutions and markets.

Crucially, the burden of going above the floor is on the state. U.S. officials have successfully used administrative discretion for decades to raise the effective capital requirements for most banks above the absolute minima—but failures and crises came anyway, leading many to argue that capital cushions were still too small.

In a delightfully legal move, Schooner would simply flip the burden. Instead of starting with, say, 8 percent and working up to, say, 15 percent, using a host of complex formulas and byzantine administrative procedures—regulations might start at 20 percent and give regulated firms a chance to argue it down to 15 percent. As she puts it towards the end of her Senate testimony, “[c]onceptually, capital regulation would be set … as ‘prudent’ capital as opposed to ‘minimum’ capital.”

This is ingenious because it flips two arguments at once—the argument over math, and the argument about its normative underpinnings. When the standard is “minimum,” the market failure paradigm dominates. In contrast, “prudent” could be defined in terms of banks’ public functions and the risk preferences of the taxpaying public.2

Schooner’s prescription is broadly in line with the precautionary trend in financial regulatory scholarship – a rich crop of proposals to limit and license financial products and activities, reflecting a healthy skepticism about financial innovation and post-crisis risk aversion on the part of the public. Hers stands out for its radical simplicity. It would require no new administrative apparatus, and, if anything, might do away with some of the complexity that has come to define financial regulation.

As Erik Gerding notes in his comment, the upside-down capital idea follows another regulatory precept—captured in Andrew Haldane’s metaphor of the dog and the Frisbee—to fight complexity with simplicity. Top economists have shown that identifying the right minimum level of capital against financial crises is incredibly hard, perhaps even harder than finding a formula for consistently catching a Frisbee. Dogs learn to catch Frisbees without formulas. Flipping capital regulation on its head might dispense with a few formulas as well.

As Gerding and Brett McDonnell rightly note in the symposium, Schooner’s inspired concept does not escape the essential criticisms directed at all bank capital regulation – namely, that regulating some firms more stringently, or more effectively, could drive finance beyond the regulatory perimeter, and spawn new regulatory arbitrage strategies. McDonnell also notes that there are risks to firms and to society from setting capital thresholds too high. Both critiques are fair, but they are not particular to Schooner’s argument. If you are going to regulate bank capital at all, it is hard to see why you wouldn’t do it upside down.

My own frustration with the article is that the absolutely brilliant core contribution is buried way too deeply for most readers to reach, and takes up much less of the text than it should. I am also uneasy about Schooner’s term for the proposal, “Top-Down Capital Regulation,” which to me connotes a clunky dirigisme, potentially overshadowing the subtle elegance of her idea.3

In the grand scheme of things, these are quibbles, perhaps pointing to an opportunity for the author to expand on her insight in another article or two.

  1. The colleague’s name is withheld until such time as he no longer need care what the editors think. []
  2. To align incentives, Schooner also argues that managers should have personal liability in the event they successfully argue for a cushion that turns out to be too low—although she does not fully develop the idea. []
  3. The existing regulatory paradigm is called “Bottom-Up,” which I associate with people power, in a world that is anything but. []
Cite as: Anna Gelpern, See. Spot. Catch. Frisbee. (… or Behold the Simple Elegance of Bank Capital, Upside-Down), JOTWELL (September 8, 2016) (reviewing Heidi Mandanis Schooner, Top-Down Bank Capital Regulation, 55 Washburn L.J. 327 (2016)),

Of Firms and Fees

Kathryn Judge, Intermediary Influence, 82 U. Chi. L. Rev. 573 (2015).

Prominent economic theories rooted in the seminal work of Ronald Coase have long suggested that firms in a marketplace exist and work to reduce transaction costs, but the explanatory powers of these theories fail to reflect some of the realities of the modern marketplace. In many instances, particularly in the financial industry, it appears that firms exist and work to increase, rather than decrease, transaction costs. In her recent article, Intermediary Influence, Professor Kathryn Judge examines this peculiar phenomenon and offers a persuasive claim that helps to explain this persistent and consequential marketplace curiosity in finance.

The central claim of Professor Judge’s article is aptly summed in the title of the piece: intermediary influence. If one wonders why certain financial arrangements are the way they are, the article suggests the answers likely lies in fees and the firms that collect them. Specifically, the article argues that:

[T]hrough repeatedly helping parties to overcome barriers to transacting, intermediaries develop informational and positional advantages relative to the parties that they serve. These advantages are critical to intermediaries’ capacity to provide value, but they also put intermediaries in a superior position to influence the evolution of institutional forms. In addition, intermediaries of a particular type will often be fewer in number and better organized than the parties that they serve. This makes intermediaries relatively better positioned to shape laws and regulations and to otherwise act to promote institutional arrangements that serve their collective interests. For these reasons, intermediaries often succeed in their efforts to promote and entrench high-fee arrangements.

(P. 590.)

To bolster her claim that certain intermediaries work to add needless transaction costs to the marketplace, Professor Judge offers evidence with case studies of financial intermediaries such as exchanges, stockbrokers, mutual funds, and credit default swap dealers. In each instance, the entrenched intermediary took action that solidified or moved the marketplace toward a high-fee position even when lower cost alternatives seemed viable. Professor Judge suggests that partially as a result of such intermediary influence, the financial industry is less efficient, more intermediated, more complex, and more fragile.

The explanatory strengths of the article are persuasive and powerful. They provide guidance for the current paths of finance, and raise questions about the road ahead. How does one pragmatically and politically go about rechanneling intermediary influence towards greater efficiency and economic welfare mindful of strong incumbent self-interest to oppose such changes? Why have the forces of new technology and greater competition been much more disruptive to entrenched intermediaries in other industries relative to those in finance? What factors make certain intermediary influence more powerful than others? Are there non-economic beneficial purposes to high fees, such as gatekeeping, that we should maintain over time? Are intermediary influence and high fees existential facets of modern finance given its complex and intermediated nature? The answers to these and other lines of inquiries find both fertile ground and green shoots in Professor Judge’s article when one thinks about the large questions looming over the future of financial markets and financial regulation.

Because financial markets are truly markets of intermediaries, financial regulation is truly regulation of intermediaries. And because intermediaries influence, they must be influenced. Thanks to the work of Professor Judge, policymakers and researchers thinking about how best to regulate the financial industry must think harder about how best to repurpose and refashion the influence of financial intermediaries towards more productive and efficient ends.

Cite as: Tom C.W. Lin, Of Firms and Fees, JOTWELL (July 26, 2016) (reviewing Kathryn Judge, Intermediary Influence, 82 U. Chi. L. Rev. 573 (2015)),

Thinking About Monitoring

Veronica Root, Modern-Day Monitorships, 33 Yale J. on Reg. 109 (forthcoming 2016), available at SSRN.

The study of organizational compliance is now proliferating in American law schools. Over the past decade, new courses, new programs, and new scholarship have focused increasing attention on this area. In recognition of the importance of organizational compliance as a free-standing field of inquiry, the American Law Institute has launched the drafting of Principles of the Law, Compliance, Enforcement, and Risk Management for Corporations, Nonprofits, and Other Organizations. This project – and the work it inspires – should advance our understanding of a framework for thinking about organizational compliance. Veronica Root’s work on monitorships, including her most recent piece on Modern-Day Monitorships, is a meaningful contribution to one piece of that framework.

Much of the existing work on organizational compliance focuses on “gatekeepers,” which reassure the public that a corporation is complying with its obligations. Professor Root has focused her scholarship on the enforcement side, helping us to understand the special role of “monitors,” which enter the scene after a compliance failure is manifest.1 The role of monitors is to investigate wrongdoing and make recommendations for future compliance. In her most recent article, Root describes “modern-day monitorships” and argues for a more nuanced understanding of these important enforcement institutions.

Professor Root traces the origins of modern-day monitorships to the familiar court-appointed monitors, which go by various names, including “master,” “special master,” “receiver,” or “trustee.” These monitors have been used for many years to assist courts along a range of responsibilities in resolving complex litigation, from fact-finding to the creation and implementation of remedies.

Professor Root contends that the traditional court-ordered monitorships served as the model for a new form of monitorship, deployed by governments or administrative agencies in a context of increased regulatory oversight. The challenge for a government faced with an organizational wrongdoer is to get the organization back on the right path, possibly over a period of many years. According to Professor Root, “In regulatory grey areas, it is often difficult to predetermine a set of mandates that an organizational wrongdoer should follow going forward.” (P. 123.) Thus, the role of monitors changed from “performing rote compliance enforcement” in the wake of a finding of wrongdoing to “assisting in the development of a remediation program.” (Id.) Meet the modern-day monitorship, used by courts, government agencies, and (increasingly) private organizations.

While modern-day monitorships can be employed in diverse circumstances, Professor Root describes four core attributes: modern-day monitors are “(i) independent, private outsiders, (ii) employed after an institution is found to have engaged in wrongdoing, (iii) who effectuate remediation of the institution’s misconduct, and (iv) provide information to outside actors about the status of the institution’s remediation efforts.” (Id.)

The most common modern-day monitorships are for purposes of regulatory enforcement, as described above, but modern-day monitorships often perform functions beyond the development of a remediation program. The modern-day monitor, like a gatekeeper, may lend reputational capital to the wrongdoer, but in this context to facilitate rehabilitation. Or, when acting under a court order, some modern-day monitors may exercise a great deal of discretion in defining and remediating past harms. Professor Root also suggests a public relations benefit (beyond the use of reputational capital) from modern-day monitorships, when the wrongdoer voluntarily hires a monitor and charges the monitor with providing a public accounting of the investigation, along with suggestions for remediation measures.

Among the many legal issues that arise from the widespread use of monitors is that “modern-day monitorships … lack a technical source of legal authority governing their use.” (P. 142.) (Note that the ALI project is not a “Restatement of the Law,” which would be primarily addressed to courts to clarify established law, but rather a “Principles of the Law,” which is to be primarily addressed to legislatures, administrative agencies, private actors, or courts where there is little established law.) Some commentators have proposed more robust legal framing of monitors, but Professor Root argues that differences in context make the development of overarching principles challenging. More specifically, she discusses the lack of desirability of one-size-fits-all rules for court involvement, transparency, confidentiality, and monitor duties. The bottom line is that “differences amongst monitorships matter when considering common issues of monitorship reform.” (P. 152.)

Professor Root’s examination of monitorships is careful and detailed, and she includes in the final section of her paper several additional considerations that “lawmakers, scholars, and the public should contemplate” as they think about monitorship regulation. (P. 153.) This piece and her previous work on the monitor-“client” relationship are worthy of close reading by anyone who is interested in advancing his or her thinking about this emerging field.

  1. See Veronica Root, The Monitor-“Client” Relationship, 100 Va. L. Rev. 523 (2014). []
Cite as: D. Gordon Smith, Thinking About Monitoring, JOTWELL (June 24, 2016) (reviewing Veronica Root, Modern-Day Monitorships, 33 Yale J. on Reg. 109 (forthcoming 2016), available at SSRN),

Concrete Suggestions Around Conflict Minerals and Corporate Supply Chains

Galit Sarfaty, Shining Light on Global Supply Chains, 56 Harv. Int’l L. J. 419 (2015).

Supply chains. Not too long ago, I found myself nodding wisely along when someone was talking about them. The truth is that my nodding signaled only that I recognized their significance as components of the modern global economy, and as objects of legal study. In no way did my nodding signal that I actually knew much about them.

These are the things I do know about supply chains: they are important; they are complex and present complex challenges; their trans-border nature makes them hard to regulate; and bad things regularly happen in developing countries, at the ends of supply chains that provide goods many of us have come to rely on. Things I don’t know about supply chains: above all, I don’t know in precise terms just how inadequate existing legal regimes – domestic, transnational, public, or private – are in dealing with supply chain problems; where the shortcomings are and the precise consequences of those shortcomings; and whether I should be hopeful or despondent about the prospect of addressing them.

Happily, Galit Sarfaty has shone new light into one aspect of supply chain regulation, through something I do know a bit about: disclosure-based securities regulation. In the process, she has illuminated the potential of domestic law in addressing the use of conflict minerals within corporate supply chains, and the significant limits of corporate conduct on the matter to date.

In Shining Light on Global Supply Chains, Sarfaty considers the mandatory disclosure requirements under Dodd-Frank Section 1502, which requires companies that are publicly traded in the US, including their foreign subsidiaries, and which manufacture or contract to manufacture certain conflict minerals, to disclose whether their minerals originate from the Democratic Republic of Congo (DRC) or its neighboring countries. When they do, the company must exercise due diligence on the source and chain of custody of their minerals, and file a Conflict Minerals Report. Sarfaty’s work quantitatively and qualitatively reviews the first round of such reports, 967 in total, filed in mid-2014, supplemented by ethnographic interviews and participant observation. As she points out, Section 1502 aims to use domestic disclosure rules to extend the extraterritorial reach of US domestic law far enough to provide some visibility into where the conflict minerals in our laptops and other electronics (along with gold and other minerals) actually come from, and the conditions under which they are obtained.

Sarfaty’s first, striking finding is that most companies show genuinely poor due diligence when it comes to understanding their supply chains, let alone mitigating risks or seeking to improve supplier practices vis-à-vis conflict minerals. 48% of companies demonstrate weak due diligence based on her careful criteria, and only 7.34% (that is, 8 of 967 reporting companies) can claim to be demonstrating strong due diligence.

As Sarfaty shows, good supply chain due diligence is hard to achieve. Supply chains can be long, and tend to be fluid. International norms on supply chains are still at an early stage of development, so there is a lack of guidance around, e.g., how much due diligence work can be outsourced to third parties, and even what counts as a “conflict” for purposes of the rule. As well, multiple different parties – industry groups, NGOs, consulting firms, and governmental bodies – are now involved in developing certification standards and sourcing initiatives. The initiatives can conflict, can be non-transparent, and in any event are generating in the context of a competition among certifiers for market share. Coordination is less the norm than competition, and ameliorating the desperate situation in the DRC is not the certifiers’ only priority. As well, of course, local security is very challenging and governance is very weak in the region, which inhibits mapping and traceability.

Then there are the factors that seem to correlate with higher compliance. Unsurprisingly, firm capacity and “social license” matter. Brand strength and company size (but not profitability, so much) are positively correlated with better compliance. Also strongly correlated is whether a company has been involved with particular international supply chain initiatives, like the Conflict Free Sourcing Initiative (CFSI). However, benefits taper off if a company is involved in more than one such initiative, presumably because at some point redundancy and even conflict between initiatives kick in. It also turns out that making things easier for companies – for example, by having independent third-party auditors certify smelters as conflict-free, as CFSI does – increases compliance. For regulation and governance nerds like me, Sarfaty’s article also enriches the conversation about the comparative benefits of harmonization versus decentralization (i.e., in the context of federalism, or improving legal standards by allowing multiple standards to operate simultaneously). It reminds us that there can be real costs associated with allowing multiple initiatives to develop alongside each other, at least in the context of urgent human rights abuses on the ground. One harmonized set of due diligence reporting requirements, which are fairly easy for companies to implement, potentially with the assistance of credible on-the-ground actors like the CFSI would apparently make conflict mineral supply chains easier to map and to manage. While over the long run, multiple competing standards may be more effective at generating optimal standards, optimality in this environment may be less important than actually making some progress, sooner.

Sarfaty’s work makes a welcome contribution to our understanding of how to improve supply chain due diligence. Hers is a positive early account of the application of domestic law to a thorny transnational problem, and Sarfaty’s thoughtful and thorough analysis helps identify the specific ways in which we may be able to envision a yet more robust and meaningful strategy for dealing with conflict minerals, human rights abuses, and corporate supply chains.

Cite as: Cristie Ford, Concrete Suggestions Around Conflict Minerals and Corporate Supply Chains, JOTWELL (May 31, 2016) (reviewing Galit Sarfaty, Shining Light on Global Supply Chains, 56 Harv. Int’l L. J. 419 (2015)),

Why Directors Don’t Direct

Adam Badawi, Influence Costs and the Scope of Board Authority, 39 Iowa J. Corp. L. 675 (2014), available at SSRN.

Over four score years ago, William O. Douglas told us that directors don’t direct. Since then, there have been multiple attempts to enable directors to direct the corporations they nominally manage, often by proposing or mandating changes in the composition of the board. Directors’ backgrounds, biases, opportunism and group behaviors have been diagnosed as both the cause and cure to the problem of director inaction.

Rather than examining directors, Adam Badawi shifts attention to those outside the board to explain why it is in the interest of the business that directors don’t direct. His focus is not on coalitions within the board, but on lobbying of the board by others in the corporation. So that these other interests don’t spend their time attempting to influence the board (and instead concentrate on activities more profitable to the business), it is essential that boards exercise little of the authority they possess. By delegating authority to management, boards constrain the investment management makes in lobbying the board.

As Badawi makes clear, restricting board activity may restrict the board’s abilities to reduce the agency costs occasioned by the separation of ownership and control. His focus is on the trade-offs. He considers, for example, the displacement of inside directors by outside ones. The gains in better monitoring of agency costs, Badawi argues, come with increases in lobbying costs, especially those imposed on the firm by the former directors. (P. 678.) As employees have non-diversifiable firm-specific capital investments, they will actively lobby the board. This lobbying may take various forms from massaging the information that the board receives to overt politicking. Because they have strong interests in the outcome, employees will impose influence costs on the firm when the board seeks to exercise its authority, “[t]o put it another way, the drag that lobbying can exert on a firm increases with every additional decision the board makes.” (P. 687.)

The trade-offs between influence costs and agency costs will be business and issue specific. Hence, Badawi argues, the deference of the business judgment rule to director exercise of their authority reflects fear of imposing influence costs on the firm. (P. 679.) As board oversight increases, agency costs might decrease, but the organizational drag of influence costs might increase. The appropriate trade-off, how board decision-making is structured, is contextual and difficult to make, perhaps especially by the board. Hence, the judicial hands-off policy is the proper default option. In an M.I.T. dissertation, Michael Powell has found a convex shape to the costs of lobbying. (P. 684.) Hence, a rule of law that required more board governance – such as a weakening of the business judgment rule – would “escalate very quickly” influence costs “in a way that is quite difficult for a court to observe.” (P. 708.)

Badawi’s account also explains why firms sometimes use outside law firms and independent consultants. Information that the board gets internally should be presumed to be influenced by the strong interests of firm employees. They may be knowledgeable, but they are interested. So, in an acquisition, a firm is likely to seek the independent but less knowledgeable opinion about whether the target is or is not a good fit for the firm. (P. 690) (even without Van Gorkom).

Badawi doesn’t claim that influence costs are the only reason why directors don’t direct (P. 692). But it is a breath of fresh air to find an article that neatly illuminates that question and that doesn’t impugn directors. One mark of a very good article article is the reaction, “of course.” And, that was my initial reaction to this article. I then thought that it is shocking that it hadn’t already been written. Badawi has his finger on something, and analyzes it beautifully. It should be much cited.

I hope this article also stimulates empirical work. If the CEO is Chairperson of the Board, what lobbying takes place? Does that influence the range of activities that the board undertakes? Do boards with CEO’s as Chairperson direct more than those without? When the General Counsel (as Board Secretary) sets the agenda, how is the legal department lobbied? There are, I believe, many more studies of intra-board politics than of firm-board politics. Badawi challenges us to undertake such research, and we should be grateful for that stimulus.

Cite as: Robert Rosen, Why Directors Don’t Direct, JOTWELL (April 1, 2016) (reviewing Adam Badawi, Influence Costs and the Scope of Board Authority, 39 Iowa J. Corp. L. 675 (2014), available at SSRN),

Constituency Directors, Loyalty, and the Corporate Objective

Martin Gelter & Geneviève Helleringer, Lift Not the Painted Veil! To Whom Are Directors’ Duties Really Owed?, 2015 U. Ill. L. Rev. 1069 (2015).

Theories of corporate law and governance that purport to explain the nature of the corporate entity, the legitimate objective of corporate decision-making, and/or the balance of corporate power have proliferated over recent decades, and the debates prompting them show no signs of abating. Some accounts place the shareholders’ interests at the core of the enterprise, while others present more embracing conceptions requiring (or at least permitting) regard for other “stakeholders” such as employees and creditors. Similarly, some accounts identify shareholders as the font of legitimate corporate power, while others present more board-centric conceptions. Adding to the complexity, various theories combine differing perspectives on the corporate objective and corporate power in differing ways, often rooting them in irreconcilable conceptions of what the corporate entity itself fundamentally is. As time passes, the arc of corporate theory would appear to bend toward fragmentation rather than closure.

In the article cited above, Martin Gelter and Geneviève Helleringer illuminate these issues from a fascinating doctrinal perspective, exploring what the persistence of so-called “constituency directors” – placed on the board by a particular individual or institution – reveals about the nature and defining objective of corporate decision-making. Gelter and Helleringer bring to the task not only deep engagement with the scholarly literature in these areas, but also considerable comparative and interdisciplinary sophistication. Drawing upon a broad range of examples from U.S., U.K., and Continental European corporate legal systems, they observe a “fundamental contradiction” manifesting itself in all of them – “the tension between the uniformity of directors’ duties and the heterogeneity of directors themselves.” Specifically, they identify an apparent “paradox” in permitting “directors’ nomination rules linked to specific constituencies” while at the same time imposing “heterogeneity-blind duties.” Building on their descriptive account of illustrative doctrinal structures, Gelter and Helleringer assess them against prevailing formulations of the corporate objective, social scientific insights, and the available empirical evidence, concluding with a normative case for reform. Their product is informative, insightful, and a pleasure to read.

Whether the director in question is a venture capital investor’s nominee, increasingly common in the United States; an employee representative appointed under a Continental European codetermination system; a minority shareholder representative; or even a government representative (with which even the United States has some recent experience under TARP), directors’ duties remain undifferentiated. “In spite of the heterogeneity of directors between and within countries,” Gelter and Helleringer find, “all major jurisdictions, of which we are aware, developed a strongly uniform duty of loyalty for all directors.” While such issues have historically loomed larger elsewhere, Gelter and Helleringer rightly observe that their salience in the United States has increased as defined contribution pensions and greater institutional dominance have produced a more active and heterogeneous investor base.

In such situations, the potential for cognitive dissonance blurring into outright conflict of interest is obvious and acute, and structures permitting constituency directors have remained workable only because of another (perhaps ironic) commonality that all such jurisdictions share, which is that “the purported objective of fiduciary duty – however formulated in theory – is not clearly defined at all.” Directors are instructed to pursue the best interests of “the company” or “the corporation,” whatever that means. Sometimes there is a simultaneous nod toward the interests of the shareholders, an instruction that effectively remains unenforceable due to structures substantially insulating board discretion (e.g. the business judgment rule). Accordingly, while clear self-dealing may be aggressively policed, more general and pervasive conflicts pertaining to business policy typically will not. For lack of any coherent substantive definition, the corporate objective effectively has been “procedurally” defined through board appointment rules – and in such cases the outcome will, as an empirical matter, often “look more like negotiation between different groups than deliberation for a common purpose.”

A particularly important question reflecting these dynamics, Gelter and Helleringer suggest, is whether constituency directors ought to be permitted to share nonpublic information with the entity appointing them. While directors “are typically subject to a duty of confidentiality that prohibits them from sharing nonpublic information from the company with their sponsor,” Gelter and Helleringer argue in their normative discussion that “permitting firms to opt out of confidentiality” may be desirable – at least where the board appointment structure effectively amounts to a negotiated resolution to long-term contracting problems among various stakeholders.

This intriguing line of normative argument could be refined and taken further, and perhaps will be in future work. Regardless, Gelter and Helleringer’s article is a rewarding read, offering a rigorous, nuanced, and insightful analysis of constituency directors and their implications for prevailing conceptions of the duty of loyalty and the corporate objective.

Cite as: Christopher M. Bruner, Constituency Directors, Loyalty, and the Corporate Objective, JOTWELL (March 1, 2016) (reviewing Martin Gelter & Geneviève Helleringer, Lift Not the Painted Veil! To Whom Are Directors’ Duties Really Owed?, 2015 U. Ill. L. Rev. 1069 (2015)),