Michal Barzuza, Quinn Curtis & David H. Webber, Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance
, 93 S. Cal. L. Rev.
__ (forthcoming, 2020), available at SSRN
Index funds have become a subject of intense scrutiny, first and foremost, because they are enormous. BlackRock, Vanguard, and State Street – the “big three,” with several trillion dollars in assets under management collectively – control around one-quarter of the stock of the S&P 500 companies. Accordingly, there is keen interest in understanding how they exercise the rights associated with that mountain of stock. As a threshold matter, why exert themselves at all, when their passive management model thrives on low fees, and therefore low costs? And why, despite these incentives, have they become increasingly vocal on sustainability-related matters, sometimes described as “environmental, social, and governance” (ESG) issues? As Michal Barzuza, Quinn Curtis, and David Webber argue in the paper cited above, the answer may relate to an overlooked dimension of the competition among these major institutions – the urgent effort to attract Millennial assets.
Whereas actively managed funds aim to beat the market, and accordingly compete on performance, index funds simply aim to match the market, and accordingly compete on price. Index funds cannot sell underperforming stocks because, by definition, they track a particular index, and they would seem to lack any straightforward incentive to engage in activism because this drives up costs and correlatively diminishes the competitiveness of their fees. As the authors acknowledge, this view of the matter is consistent with evidence showing that “index funds vote their proxies, but rarely initiate shareholder action, and have small – but growing – corporate governance operations.”
Nevertheless, Barzuza, Curtis, and Webber document “extensive index fund activism around board diversity and other social issues.” Notably, these index funds “have not been afraid to aggressively challenge boards when companies are not responsive to calls for gender diversity, including voting against current directors” – an approach initially adopted by State Street and followed soon thereafter by others. Meanwhile, climate change has also become a major focus, with BlackRock leading the charge and others following suit.
How might this be squared with the fee structure and associated incentives described above? Given the mixed results of the empirical literature, the authors argue that “conventional shareholder value creation is unlikely to explain index funds’ commitment to promoting diversity.” Meanwhile, given the Department of Labor’s skepticism regarding the compatibility of ESG investment with investment duties under ERISA – applicable to 401(k) plans, from which “the big three hold vast sums” – they argue that “regulatory uncertainty around index funds’ social activism … is evidence against the view that these governance interventions are explained as a means of staving off regulatory intervention.”
A more plausible explanation, they argue, lies in a different direction – an increasingly heated competition to secure assets from investors who increasingly care about these issues. “In the coming decades,” they observe, “between $12 and $30 trillion will be transferred to Millennials,” generally understood to mean those born in the 1980s and 1990s. This will represent “the largest intergenerational wealth shift in history,” and a growing body of research indicates that Millennial investors are more likely to invest based on ESG considerations than are others. These developments have not been lost on the big index funds, which “are taking Millennial wealth seriously.” Accordingly, “competition for their assets – and future assets – has already begun in earnest.”
The authors’ novel insights certainly provide a helpful means of understanding the index funds and their role in corporate governance generally. At the same time, however, the evidence that they marshal to support their argument may also illuminate the degree to which various forms of sustainability-related initiatives might plausibly be advanced by this important category of institutional investors. Notably, the tension they cite between the desire to “avoid challenging management because they fear loss of access to companies’ 401(k) platforms,” on the one hand, and the desire to appeal to Millennial investors, on the other, may help explain why the index funds have pursued some ESG issues more energetically than others. For example, they suggest that “fear of confronting management may explain index funds’ more cautious approach to climate change so far.” Whereas “Millennials care about both diversity and climate, the gender composition of a corporate board is a far less sensitive issue for most firms than their carbon footprint.” Accordingly, index funds may “intervene aggressively when the cost is low and tread lightly when it is not.” In each context, they argue, it is “a straightforward cost-benefit calculation.”
Clearly much work remains to be done regarding the significance and impacts of the business models and ESG-related activism of index funds. Likewise, Millennial wealth and values will remain dynamic subjects of study for decades to come. In the meantime, Barzuza, Curtis, and Webber’s analysis sheds new light on their complex interactions, and reveals dynamics that may have profound impacts on these investment structures and their potential to promote corporate sustainability.
Cite as: Christopher M. Bruner, Index Funds and Millennial Assets
(March 22, 2021) (reviewing Michal Barzuza, Quinn Curtis & David H. Webber, Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance
, 93 S. Cal. L. Rev.
__ (forthcoming, 2020), available at SSRN), https://corp.jotwell.com/index-funds-and-millennial-assets/
William Moon’s thought-provoking recent paper, Delaware’s New Competition, examines whether there exists an international market for corporate law. Moon’s paper captures a trend in which certain offshore jurisdictions are emerging as corporate lawmakers and attracting publicly traded firms. Specifically, the paper analyzes how a small group of island nations, or “havens”, are developing legal infrastructures that attract public companies. It explores how and why foreign nations might compete for a market share of “American” corporations.
Paper’s Central Findings
Moon’s paper moves beyond the domestic charter competition narrative centered on Delaware to explore its international and comparative dimensions. The popular view of offshore incorporation is that it is largely driven by tax considerations. (Pp. 1417–18.) Moon considers another aspect of the jurisdictional product bundle: corporate law.
To the extent that the internal affairs doctrine applies to foreign incorporation, there is presumably an international market for corporate law. (Pp. 1418–22.) The article considers whether companies with (i) significant US-based operations that might incorporate in a foreign jurisdiction or (ii) primary operations outside of the United States but seeking to raise capital by listing on a US-based exchange shop for corporate law produced by foreign nations. (P. 1424.)
The article focuses on three jurisdictions—Bermuda, the British Virgin Islands, and the Cayman Islands—that have more in common than their location in paradise. In fact, they share several key characteristics with Delaware—(i) credible commitment due to a reliance on fees; (ii) limited interest group dynamics; and (iii) dispute settlement capabilities—but the substance of their law diverges from Delaware’s in distinct ways.
Credible Commitment and Fees
Like the small state of Delaware, these small islands are dependent on corporate fees (Pp. 1430–32), which increases their sensitivity to private-sector corporate governance preferences. For example, the British Virgin Islands generate significant government revenue from corporate registration fees—as much as 58 percent in 2017. (Pp. 1430–32.)
Limited Interest Group Dynamics
The paper provides an interesting discussion of how offshore jurisdictions make corporate law. In some ways, the process loosely resembles the dynamics in Delaware. The similarities may explain how these jurisdictions can easily adapt their law to attract companies. Prominent private-sector lawyers and law firms are instrumental in writing the content of corporate governance rules in leading offshore jurisdictions. In essence, they function as de facto lawmakers. Local interest groups also benefit from foreign offshore incorporations. The local private sector helps firms navigate local administrative requirements, and some jurisdictions even mandate that companies have a resident director. (Pp. 1432–37.)
Automatically creating a judicial system like Delaware’s is hard for offshore jurisdictions. To meet the challenge, they have launched specialized business courts with arbitration-like dispute settlement features, including greater privacy. (Pp. 1437–43.) Moreover, whereas Delaware judges have to be Delaware citizens, offshore jurisdictions can recruit foreign citizens who are highly regarded judges and experienced commercial lawyers.
Substantive Law Differences
Despite similarities, leading offshore jurisdictions diverge from Delaware when it comes to substantive law. Whereas Delaware relies on extensive caselaw and a litigant-driven system, offshore jurisdictions have enacted relatively clear-cut statutory laws that are more prescriptive in the absence of case volume. Their laws are also arguably more permissive, with fewer mandatory rules. Companies desiring to opt out of some mandatory rules under the US corporate law regime can incorporate offshore. These jurisdictions offer limited protections for minority shareholders; derivative suits are rare; and shareholder inspection rights are limited and, in some instances, forbidden. (Pp. 1444–50.) Corporations can even limit, opt out of, or waive certain fiduciary duties, such as the duty of loyalty. Bermuda, an extreme case, allows corporations to waive all fiduciary duty claims against directors and officers, except in the event of fraud and dishonesty. (Pp. 1444–50.)
Paper’s Implications for Scholarly Debate and Future Research
Scholars have thoroughly debated Delaware’s jurisdictional dominance and reached a point of general consensus: despite several attempts, no other states pose a significant competitive threat to Delaware’s dominance, and federal government encroachment is the only palpable domestic threat. A few scholars have focused on the international and comparative dynamics of incorporating in offshore jurisdictions, but most focus on tax-inversion strategies.
A New Frontier of Competition
Moon’s paper builds upon the corporate-chartering conversation by highlighting a new frontier of competition. Even if robust US interstate competition is mostly a myth, leading offshore “havens” may compete for incorporations. Certainly, at the moment, the degree of competition between offshore jurisdictions and Delaware is limited, but the incentives and contextual factors necessary for competition are in place.
Most of the discussion concerning offshore jurisdictions presumes that taxes are the overwhelming reason that companies decide to incorporate offshore. Moon introduces more nuance. The incorporation decision loosely resembles the purchase of a bundled product composed of many features. When incorporating, companies and their advisors presumably consider such factors as corporate law, dispute settlement, taxes, and other regulations, but, in practice, these jurisdictional features can be difficult to decouple. The article underscores the need for future research to capture the deeper nuances of these considerations that may lead to offshore incorporation.
A Race to the Bottom?
Critics might assert that the emergence of offshore jurisdictions reflects a race to the bottom, with minimal standards for corporate managers and limited shareholder protections. Meanwhile, proponents can argue that significant legal variation among these jurisdictions makes this judgment too sweeping. Instead, offshore jurisdictions may offer an extended menu of corporate-law options and serve as laboratories for innovation.
Where are the other Stakeholders?
Beyond limiting minority shareholder rights, offshore incorporation may also sidestep stakeholder and third-party interests. Small offshore jurisdictions, like the small state of Delaware, are insulated from robust interest-group dynamics which, in turn, may result in corporate law that is less receptive to third-party concerns.
In conclusion, Moon’s paper is a must-read for scholars interested in the international dimension of the incorporation debate.
History is the key to understanding U.S. banking law and regulation. History also repeats itself. Professor Art Wilmarth’s new book sheds new light on these oft-repeated propositions. It tells a multi-layered, richly textured story of how the rise of U.S. universal banks – diversified financial conglomerates clustered around publicly-backed banks – led both to the Great Depression of the 1930s and the Great Recession of the post-2008 era. On that basis, it makes a case for breaking up today’s universal banks and shadow banks and reestablishing the legal wall separating banking from the capital markets.
The book has been eagerly anticipated by all of us in the banking law and financial regulation academic community. Professor Wilmarth has devoted much of his long and fruitful scholarly career to studying the dysfunctional effects of excessive conglomeration in the U.S. banking sector. His knowledge of the subject is unparalleled (as some of us often joke, Art has probably forgotten more banking law than we will ever manage to learn!). Taming the Megabanks brings all of that immense knowledge into a compelling narrative of a decades-long process that gave us today’s corporate behemoths: Citigroup, JPMorgan, Bank of America, and a few other familiar names.
Professor Wilmarth traces the origins of America’s universal banks back to the late nineteenth-early twentieth centuries, when large commercial banks began expanding into lucrative securities underwriting and trading. The book shows how, in the wake of the World War I and through the “roaring 1920s,” commercial banks’ competition with investment banks fueled incredible speculation in stocks and bonds, which ended in the momentous market crash of 1929. It was in response to the Great Depression that followed it that Congress adopted the Glass-Steagall Act of 1933, which prohibited deposit-taking banks to engage in, and to affiliate with, securities and other financial services firms.
Professor Wilmarth gives a fascinating account of the “long and tortuous journey” that culminated in the passage of the statute. His description of banking industry executives’ public appeals to “service to community” and “market efficiency,” in particular, made me chuckle with weary recognition. It is, of course, hardly surprising that big banks fought the proposed prohibition on mixing deposit-taking with speculative trading with all their might. In subsequent decades, they worked even harder to get around and ultimately to dismantle the Glass-Steagall regime. Professor Wilmarth walks the reader through the intricate sequence of legal and regulatory actions from the early 1980s on, which gradually undermined the prohibition on banks’ securities trading and underwriting activities, leading to the formal repeal of that prohibition in the Gramm-Leach-Bliley Act of 1999. The book discusses the growth of mortgage securitization and derivatives markets, along with the growth of “too big to fail” financial conglomerates, driving the “toxic credit bubble” that finally burst in the fall of 2008.
Drawing the many parallels between the Great Depression and the post-2008 Great Recession, Professor Wilmarth focuses on the fundamentally different character of the legislative response to these two situations. He criticizes the Dodd-Frank Act of 2010 for its failure to restore the institutional wall between publicly-backed banks and the increasingly unstable shadow banking sector. He concludes the book by arguing in favor of adopting a new Glass-Steagall Act, as the key reform necessary to diminish systemic risks in the financial system, reduce the size and disproportionate market power of bank-centered conglomerates, and protect the public from devastating financial crises.
Undoubtedly, not everyone will agree with this idea. Some may find Professor Wilmarth’s proposal too radical – and perhaps a bit anachronistic. Others may point out that it is not exactly novel: in recent years, there have been multiple calls for, and attempts to introduce, a new Glass-Steagall Act. Yet, everyone with an interest in, or desire to understand, U.S. financial regulation and prospects for reform should read Professor Wilmarth’s book. It is incredibly well-researched, densely packed with facts, deep, and thoughtful. It makes a strong case for an important structural change. And it is bound to be part of the canon.
Sarah C. Hann, Corporate Governance and the Feminization of Capital
(Dec. 8, 2020), available at SSRN
In her working paper, Corporate Governance and the Feminization of Capital, Sarah C. Haan unearths the lost history of female shareholding and the crucial role gender bias and stereotypical depictions of women may have played in the creation of a corporate law system and ideology that promoted managerialism—to the benefit of white males. From the beginning of the twentieth century to the start of the Great Depression, corresponding with the rapid rise to dominance of the modern corporation, women had grown from an insignificant portion of the nation’s stockholders to a majority in many publicly traded firms; by the mid-1950s women were a numerical majority of all owners of publicly-traded stock. In the two decades before the Great Depression, reformers worried about the looming influence of the emerging modern corporation, and many advocated protecting and reinforcing shareholder power as the appropriate antidote.
The Great Market Crash of 1929 and the election of Franklin Roosevelt in November of 1932 provided the crisis and the opportunity to remodel corporate governance. However, rather than increasing the shareholder governance role, corporate theorists and policymakers preferred laws and legal institutions that fostered and supported managerialism. Haan convincingly argues that the path taken corresponded with gender-biased beliefs concerning the capabilities and appropriate roles of men and women, and that Berle and Means’ The Modern Corporation and Private Property (“The Modern Corporation”), published in the summer of 1932, played and continues to play a central role in how corporate law is theorized and understood.
As the early years of the twentieth century unfolded, corporate managers, policymakers, and theorists noticed and commented on the rapid emergence of women as stockholders. As the bull market of the 1920s took flight, brokerage firms targeted women stock purchasers, and the proportion of women in the total stockholding census continued to rise. Nonetheless, as Haan meticulously details, commentators, even progressives, uniformly portrayed women as lacking the capacity or experience to make investment decisions or participate in corporate management. Women were cast as inherently passive and needing protection; their proper action field was the home, not the corridors of corporate power. One of many comments cited by Haan is that of William Ripley, writing in 1927:
The average stockholder is entirely unqualified to engage actively in management. For a surprisingly large number of great corporations more than half of the shareholders are women—in American Telephone for 1926, 200,000 of the 366,000 were on the distaff side. Such a multitude are ill-fitted by training—begging the moot point of sex—to govern directly, less so than in politics. These business issues are far less simple, far less moral, and they make less appeal to the imagination than those in the field of government.
Ripley’s representative comments are particularly interesting given his mentoring relationship with Adolf Berle, the principal author of The Modern Corporation, and they occurred just as Berle and his research assistant Means were beginning work on their seminal opus. When published in 1932, The Modern Corporation captured influential citizens’ attention in the run up to, and early stages of, the New Deal. It provided an empirically-rich account of the extent to which the corporation had come to dominate many sectors of the American economy during the first three decades of the twentieth century, and how many corporations were now effectively controlled by their managers due to the wide dispersal of stock ownership. Moreover, policy makers and lawmakers were given a sense of urgency by Berle and Means’ prediction that management control and shareholder dispersal would steadily increase, and that the old model of an entrepreneur-controlled firm, like the Ford Motor Company, would become the rare exception.
What Haan adds to our understanding of Berle and Means’ account of the modern corporation and its influence is the hidden role of gender bias. In the rich empirical tapestry Berle and Means wove, one important datapoint was missing—the gender of the modern corporation’s shareholders. While ignoring gender in their compilation of stockholder data, Berle and Means persistently characterize stockholders as intrinsically passive, a term which Haan persuasively argues was well understood at the time as a prototypically feminine trait. Moreover, argues Haan, while shareholder dispersion was then well understood and so termed, The Modern Corporation is the first important work to term stockholding as by its very nature passive; passivity was not a choice but a structural reality, much as society then viewed the female as inherently unfit to participate in the rough and tumble world of business. And given the inescapability of their passive “feminine” nature, Berle and Means argued that stockholders had agreed to a role subordinate to managers, who, of course then as now were nearly all men, a fact The Modern Corporation also ignored.
Haan’s working paper proceeds from the New Deal to the present, providing vignette after vignette of the rise of female stock ownership and the almost complete failure of corporation managers, lawmakers, or theorists to accord or support an active management role for stockholders. She then traces the decline of female stock ownership as institutions gradually displaced natural persons of all genders. She, then sketches the consequence of the rise of institutional stock ownership—the effective masculation of stock ownership—given the male dominance of stock fund management, and the accompanying shift in corporate law and theory to better accommodate a more active shareholder role.
Haan’s working paper is a sweeping, provocative, and almost totally new synthesis of long-forgotten historical details, coupled with a beginning examination of currently dominant corporate law theories and the centrality of stockholder passivity to those theories. She asks her readers to consider the question that lurks throughout her paper: “Does it matter if a concept so fully embedded in our discipline originated in gender bias?” Haan argues that it does, and describes a research agenda that emerges for those who agree.
This is a must-read article for every teacher and student of corporate law. One can enjoyably digest the text in one sitting, and then devote countless hours to exploring the incredibly rich footnotes and cited sources. Regardless of whether one agrees with Haan’s conclusions, a reader will take away a much more nuanced understanding of the nature of the modern corporation and the gender biases which it still reflects.
Fifteen years ago, U.S. legal scholarship treated central banks like the neglected stepchildren of bank regulation and administrative law: hardly anyone wrote about them, and no one who did not work for them seemed to care. The financial crisis that began in 2007 put the Federal Reserve, the Bank of England, and the European Central Bank in the middle of national and global crisis response strategies, and instantly made central banks the center of attention in a rich and fast-growing legal literature that continues to attract exciting new scholars.
Nonetheless, ceding central banks to economists for so long turned out to be costly: lawyers have spent much of the last decade fleshing out the underlying assumptions and basic terms of the debate, and deciding whether and how to assimilate economists’ theories of central banking into their own. The foundational question of distribution—how central banks’ monetary policy and financial stability activities distribute resources and allocate losses from crises among constituents—has lingered especially awkwardly over this area.
The slightly-stylized standard view associates distribution with fiscal policy, politics and legislatures. In this view, monetary and financial stability policies of the sort conducted by central banks do not distribute: they are for everyone at once, no one in particular, and best left to independent technocrats. This standard view is increasingly at odds with public perceptions of central banks as purveyors of bailouts for the few and peanuts for the rest. The disjunction can become a big political problem, freshly salient in the face of the multi-trillion-dollar response to the COVID-19 pandemic. The pandemic response again put central banks at the center, and took me back to Nadav Orian Peer’s pre-pandemic article situating the Federal Reserve at the intersection of political battles over corporate concentration, regional and sectoral development and, of course, money.
Orian Peer’s claim is that the Federal Reserve’s Lender of Last Resort (LOLR) function, which has been analyzed almost exclusively in financial stability terms—preventing and stopping contagious bank runs—represents a political settlement over credit allocation at the start of the 20th century.
In conventional textbook accounts, the LOLR stands ready to lend to solvent but illiquid banks in the face of panic withdrawals by depositors. It solves a coordination problem. In theory, the LOLR does not take credit risk because the solvent bank puts up good collateral for the emergency loan. In practice, central bank collateral eligibility can become a pitched political battle, because an asset that can be pledged to the central bank in exchange for cash when markets freeze up is way more liquid—and therefore way more valuable—than one that cannot be exchanged for cash. This in turn invites questions about capture, which dominate progressive accounts of LOLR.
Orian Peer’s article challenges conventional accounts in a way that is considerably more granular and interesting than a capture story. He focuses on three sets of constituents: large corporations, newly arrived on the scene in the mid-19th century, small businesses in East Coast urban areas, championed by Democrats, and Midwestern farmers. The three groups had very different credit needs, and used different instruments to access credit against the background of massive reserve concentration in New York City, which had become entrenched under the National Banking Acts in the aftermath of the Civil War.
Rapidly growing corporations primarily sought long-term funding for capital investments, mergers, and acquisitions. They issued stock and longer-term debt in the securities markets, which in turn relied on speculators’ willingness to buy these securities on credit. Speculators primarily financed themselves with very short term, secured, and therefore relatively cheap “call loans” from banks, which preferred call loans to other assets for their cash-like liquidity. Orian Peer cites contemporary sources that put call loans at nearly 10 percent of all bank deposits in the system shortly before the Federal Reserve Act was passed. Call loans were notoriously volatile—when banks needed cash, they called the loans—deepening and amplifying the link between commercial banks and the stock market.
Banks’ demand for cash was heavily seasonal. Farmers in the Midwest borrowed during planting season, often with no ability to repay until harvest time. Agrarian interests sought to distribute reserves more evenly across the United States (dethroning New York), boost the supply of long-term credit for farm economies in the West, and stabilize seasonal fluctuations in credit supply. They pressed for the new central bank to accept “accommodation loans” of nine months or longer as collateral for its liquidity support. In contrast, small businesses in urban areas focused on short-term “commercial paper,” working capital financing from the securities markets, with maturity of up to 90 days—for instance, to tide a merchant over between the purchase and sale of their inventory.
Abstracting from the details of the historical account, debates over collateral eligibility for call loans, commercial paper, and accommodation paper —as over Greek government securities, U.S. municipal bonds, car loans, home mortgages, and small business loans a century later—are not just about stopping bank runs. They are at least as much about who controls the supply of credit, about whether large corporations get to grow bigger and industries more concentrated, about the value of farmland and the prospect of stability in neglected regions and sectors of the economy. The article makes the connection between financial stability and credit allocation feel intuitive, and helps frame more fruitful lines of inquiry into the distributive work of central banks.
Cite as: Anna Gelpern, Central Banks’ Distribution, Revisited
(November 16, 2020) (reviewing Nadav Orian Peer, Negotiating the Lender of Last Resort: The 1913 Federal Reserve Act as a Debate over Credit Distribution
, 15 N.Y.U. J.L. & BUS.
367 (2019)), https://corp.jotwell.com/central-banks-distribution-revisited/
Mariana Pargendler, Veil Peeking: The Corporation As a Nexus for Regulation
, _ U. Pa. L. Rev.
_ (forthcoming), available at SSRN.
It is time to retire the term “veil piercing” from debates about corporate rights. Scholars have been drawn to the veil piercing language because of the tendency of courts to ignore the separate legal personality of a corporation when determining whether it may assert a particular constitutional or statutory right. For example, in Burwell v. Hobby Lobby Stores, Inc., the Supreme Court looked to the religious beliefs of the shareholders in allowing the corporation to claim protection under the Religious Freedom Restoration Act. Yet cases like Hobby Lobby, in which shareholders assert a corporate right to avoid an otherwise applicable law or regulation, are quite different from veil piercing cases in which creditors seek to access shareholder assets in satisfaction of a corporation’s debt. These deviations from following the general rule of “corporate separateness” are analytically and functionally distinct.
In her forthcoming article, Veil Peeking: The Corporation As a Nexus for Regulation, Professor Mariana Pargendler gives us new language for discussing the variety of circumstances in which the law looks behind the corporation or disregards its separate legal personality. Pargendler starts by reviewing the concept of asset partitioning as an essential characteristic of the corporate form. Over the past two decades, distinguished scholars have illuminated the importance of asset partitioning for establishing the key corporate features of entity shielding, limited liability, and capital lock-in. But, as Pargendler explains, the partitioning between the assets of the corporation and those of its shareholders is only one dimension of corporate separateness. Corporate legal personality also separates the legal or regulatory spheres of the corporation from its shareholders—she terms this “regulatory partitioning.” And when the general rule of separate legal or regulatory spheres is disregarded, and shareholder rights or detriments are imputed to the corporation, she calls this “veil peeking.”
The article is at once both creative and classic. It nimbly draws connections between diverse areas of law such as antitrust, discrimination, and tax, to observe a basic yet important characteristic of the corporate form: it exists in a separate legal sphere from its shareholders. That is, the legal rights, duties, privileges, and detriments of a shareholder are generally not projected onto the corporation, which instead has its own separate existence that functions as a nexus for regulation.
For instance, a shareholder might have a race, nationality, jurisdiction, and criminal status that is different from the corporation in which she has invested. This concept is no small matter—the separate legal life of the corporation from its shareholders allows for the operation of large-scale enterprise with numerous shareholders and transferable shares. Corporations and stock can be valued irrespective of shareholder identity. Regulatory partitioning additionally presents costs as well as benefits—because the corporation serves as a separate nexus for legal attribution, it can facilitate regulatory arbitrage.
Moving beyond these foundational observations regarding regulatory partitioning, Pargendler’s exploration of the veil-peeking exception shows that it arises in a variety of circumstances, resulting in both shareholder-friendly and shareholder-unfriendly outcomes. Veil peeking might at times permit the assertion of shareholder rights against the state or ascribe to corporations some of the constraints applicable to the individuals that control them.
Given the varying regulatory contexts in which these issues arise, a singular test for veil peeking does not emerge—yet here again, Pargendler’s thoughtful analysis helps shine a light on the range of approaches and their distinction from the concept of veil piercing. The article admirably begins the task of drawing together the threads of a centuries-long struggle with the question whether to ascribe the legal rights or detriments of shareholders to the corporation. Pargendler brings fresh perspective and order to the topic, providing corporate law thinkers with the opportunity to make connections to other areas of law and to see with new eyes the essential characteristics of the corporate form.
Vincent S.J. Buccola, Jameson K. Mah, and Tai Zhang, The Myth of Creditor Sabotage
, __ U. Chi. L. Rev.
__ (forthcoming), available at SSRN.
I love really good contrarian papers. They teach me things, and they don’t come along very often. Let’s face it, we academics tend to run in herds and our work tends to conform to our herd’s paradigm. Now, there may be more than one herd roaming in a given field—in corporate law we have at least three and maybe more—so that even the most argumentative, tendentious piece is less contrarian than it is directed at an opposing herd’s paradigm. The contrarian paper I have in mind works differently. It takes aim at a basic assumption shared amongst all members of all herds and tells us that that’s not what’s going on at all.
I also love really good papers about derivatives. There are certainly more than a few of these, but they don’t add up to very many given the importance of the subject matter and the concomitant need for investigation and learning. Corporate law professors for the most part don’t want to go there, preferring the comfier and less technically demanding precincts of corporate governance.
“The Myth of Creditor Sabotage,” forthcoming in the University of Chicago Law Review and co-written by Vincent S. J. Buccola, an Assistant Professor at Wharton, Jameson K. Mah, an Investment Analyst at Cyrus Capital Partners, and Tai Zhang, a member of the Wharton class of 2020, hits both of these buttons. It is a really good, deeply contrarian paper about credit derivatives. I knew it was going to be special when the sheer orneriness of the introduction gave me a pleasant jolt. My pleasure grew as the analysis unfolded.
So what sacred cow is being targeted by Buccola, Mah, and Zhang (BMZ)? I’ll describe it in herd terms. Corporate law professors of all stripes are constantly on the lookout for skewed incentives. This is most clearly true of law and economics types (“skewed incentives lead to suboptimal outcomes”) but is hardly their exclusive provenance (“self-dealing is unfair”). Find a skewed incentive and an unaccountable actor and you’ve got law review paydirt. Such papers often conclude with a call for law reform but need not do so. One can just as easily write a paper arguing against law reform on the ground that market controls assure backstop correction if not full accountability (whatever that is). CEOs, controlling shareholders, and plaintiffs’ lawyers are corporate law’s leading examples of unaccountable actors afflicted with skewed incentives. But the cast of nefarious characters grows all the time. We now hear about index funds, asset managers, investment bankers, proxy advisors, and, of course, hedge funds. I have written more than a few of these papers myself.
BMZ target the conventional wisdom surrounding the most recent development in the history of opportunistic hedge fund value destruction—the bankruptcy of Windstream, a large telecommunications provider, as a result of successful litigation by Aurelius, a net short vulture fund. The story is long and technical, so if anything confuses the reader of the brief summary that follows, the best palliative is to read BMZ. The thing to bear in mind is that the New York financial community (especially the corporate bar) was mesmerized as these events unfolded. Windstream-Aurelius was in 2017-2019 what Unocal, Revlon, and Paramount were in earlier decades.
Windstream did a complex asset partition to avail itself of REIT-based relief from double taxation. New legislation was closing the loophole, so Windstream needed to hustle. An internal sale-leaseback to and from a new shell subsidiary is the standard means to this particular end, but in this case it ran up against a sale-leaseback covenant in a trust indenture covering an issue of Windstream’s 6 3/8% Notes. To end-run the covenant, Windstream reconstituted itself with a new top-tier holding company and had the holding company take the lease back from the new sub asset transferee. Now, the property transferred continued to be used by the original asset transferor, the corporate obligor on the 6 3/8% Notes. But there was no lease to it from the holding company, which was now the nominal lessee. Instead, there was just a vaguely denominated arrangement under which payments flowed from the transferor-obligor using the assets to the holding company. (Are you still with me?) If the arrangement was not a “lease” within the meaning of the sale-leaseback covenant, there was no violation.
The bondholders let the deal go upon its completion in 2015. Nothing happened for the succeeding two years. Then Aurelius showed up as the holder of the majority of the 6 3/8% Notes, purchased at a discount. (An outright majority is necessary to assure an absolutely unimpeded right to enforce an event of default under the covenant and accelerate the entire bond issue.) Aurelius sued. Windstream defended with a literal read of the indenture and a backdoor attempt to upset Aurelius’s majority control of the bond issue. The indenture was openended, permitting the issue of more 6 3/8% Notes. Windstream set up an exchange offer of new 6 3/8% Notes to holders of its other bond issues, pursuant to which it minted enough new 6 3/8%s (and consents to waive the covenant) to undercut Aurelius’s lawsuit.
Windstream lost anyway. In U.S. Bank National Association v. Windstream Services, LLC, 2019 WL 948120 (S.D.N.Y.), Judge Furman rejected its reading of the sale-leaseback covenant, going with a substance over form interpretation. He also threw out the votes of the new 6 3/8% Notes, based on some highly technical limitations on new note issuance set out in the indenture. It is a well-executed, straightforward opinion, well within the ordinary interpretative parameters of bond cases decided over the past several decades.
Now for the twist in the wrist of the story. The Southern District’s judgment vested the acceleration of the 6 3/8%s, causing the cross-default clauses in Windstream’s other bond issues to go off like firecrackers. Windstream filed in chapter 11 two weeks after the Southern District’s opinion came down, at great cost not only to its shareholders but to its bondholders. It was a loss that was not shared by Aurelius, provided that Aurelius was net short as a credit default swap (CDS) protection buyer. And, as Bloomberg’s Matt Levine told us, everybody in the financial community assumed that to have been the case. The bankruptcy filing was a CDS credit event, leading to payout to the CDS protection buyer of the difference between face value and the post-bankruptcy value of the bond. On this read, Aurelius, a financial predator, successfully had inflicted suffering on all other Windstream constituents as it pursued a jackpot payoff conditioned on the company’s destruction. Much wailing and teeth-gnashing followed in the financial press and in the blogsphere. Creditor sabotage—covenant enforcement by a net short hedge fund—was corporate America’s Big New Problem. Indeed: Has there ever been a less accountable, more incentive incompatible player than Aurelius?
Now to BMZ, who do a deep dive into complex mechanics of bondholding, credit protection, and solvency to rebut the Big New Problem diagnosis. The net short play, they say, makes sense only to the extent that bankruptcy is the probable result, and that critical chapter 11 filing follows only to the extent the target runs out of liquidity. BMZ show that these days even distressed companies have places to turn to stay afloat. In fact, the proliferation of CDS has expanded the set of liquidity sources—in recent years protection sellers have been seen extending credit to distressed issuers of reference securities (if only to tide the securities’ issuer over until the CDS contracts’ expiration dates).
BMZ’s theoretical framework is Coasian. They show us a long cast of interested parties with stakes in keeping the target out of chapter 11 and the means to effect that result by mutual agreement. A beneficial trade, they say, can be expected. Happily, this is not a Cartoon Coasian solution where a Chicago Wizard waves a magic market wand and makes everybody better off. The authors acknowledge and confront numerous frictions. It is worth noting that such an account would not have been credible three decades ago, when everyone assumed that incentive skews and bondholder unaccountability made it impossible to solve problems of distressed issuers outside of bankruptcy. Things have changed since 2008, as the practitioners have developed a new spaces for successful contractual composition. In this new environment, BMZ’s Coasian move is quite plausible.
BMZ, having gotten this far, still have a problem. How can creditor sabotage not be the Big New Problem when we just saw a net short saboteur bring down a big company and make a killing? In the paper’s second part, BMZ meet this objection with a case study of Windstream-Aurelius. It makes for gripping reading. They run the numbers, reconstructing Aurelius’s position and laying out the stakes and returns and appraising the risks. The incentive take is that Aurelius went into the engagement to enforce the trust indenture and pick up the difference between the bond’s accelerated face value and the discounted value of the bonds at purchase (or such lesser amount as agreed to in a settlement); Aurelius, viewed ex ante, had no incentive to pursue the objective of pushing Windstream into bankruptcy and collecting on CDS. Per the terminology of Marcel Kahan & Edward Rock, Hedge Fund Activism in the Enforcement of Bondholder Rights, 103 Nw. U. L. Rev. 281 (2009), Aurelius sought to levy a “breach tax” and not to destroy the company. The ultimate negative result stemmed mostly from bad decisions made by Windstream’s managers, who misjudged the risks and stonewalled when they should have settled. The account is very, very well done, and teaches volumes about investments in distressed bonds and CDS.
The authors close with a succinct discussion of policy implications. They brief current positive law and contractual solutions to the Big New Problem with equanimity. No policy axes are ground even as caution is counselled. They also address implications “for rhetoric:” If creditor sabotage is a nothingburger, why all the brouhaha? A myth is being spun, say BMZ, (1) because it suits the interests of corporate managers, (2) because vulture funds “revel in a Machiavellian ethos,” and (3) because of “general anxiety about financialization.” Fair enough. I would add a fourth explanation, though. When managers transfer value from bondholders to their shareholders with tricked up asset partitions and stilted, literal readings of language in indentures, the bondholders are not supposed to win even as they’ve just been screwed. The managers after all are just doing their fiduciary duty to maximize shareholder value and the bondholders have skewed incentives (true) and are unaccountable (also true). The skewed incentive-unaccountability glove does fit. But not well. I prefer a different characterization, viewing the fact pattern not as “corporate governance” but as a case of contract performance, breach, and enforcement. Performance and breach is a world of tradeoffs where optimality has little to do with the present matters for decision. The value implications have to be left over for the future. And, if a contractual allocation has turned out to be dysfunctional—and this happens all the time in debt contracting—the term in question needs to be redrafted in the next generation of bond contracts. This too happens all the time, with the Big New Problem being solved as new money gets loaned. Finally, when a clever asset partitioning ploy goes sideways, managers shouldn’t stonewall. They should follow BMZ to stop posturing, consult Coase, and settle.
Cite as: Bill Bratton, Big New Problem Deflated
(September 8, 2020) (reviewing Vincent S.J. Buccola, Jameson K. Mah, and Tai Zhang, The Myth of Creditor Sabotage
, __ U. Chi. L. Rev.
__ (forthcoming), available at SSRN), https://corp.jotwell.com/big-new-problem-deflated/
Yonathan A. Arbel, Payday, 96 Wash. U.L. Rev.
1 (forthcoming 2020), available at SSRN
The unfolding pandemic has been an incredible change agent. In business, it has upended the rhythms and routines of work and operations in pedestrian and profound ways. It has accelerated anticipated changes and forced unforeseen changes. It has pushed us to examine and re-examine what was normal and necessary in the old ways we work, in the old operations of our businesses.
In his forthcoming article, Payday, Professor Yonathan Arbel examines the old, longstanding business practice of payday. In particular, he looks into why so many workers only get paid on one day for their continuous daily labor despite numerous advances in financial technology. As he succinctly put it at the start of his article:
While trillions of dollars are exchanged in online transactions—safely, cheaply, and instantaneously—workers still must wait two weeks to a month to receive payments from their employers. In the modern economy, workers are effectively lending money to their employers, as they wait for earned wages to be paid.
Through thoughtful research and argument, Professor Arbel methodically critiques the historical, legal, social, and economic explanations for our current system of payday. His critiques lead him to conclude that our present payday practice is the result of outdated legislation and stale regulation that have failed to keep up with extraordinary advances in business operations and technology.
This mismatch between legislation from a bygone era imposing an artificial and anachronistic business practice on the modern worker has had significant social and economic consequences. Employers ostensibly receive an interest free line of credit from their employees because they receive labor weeks in advance of actual payment. Employees, on the flip side, are sometimes forced into ruinous and predatory gray and black financial markets trying to make ends meet while waiting for their payday.
To alleviate this employer-employee disparity, Professor Arbel argues for the abolishment of the traditional payday, and a transition to a system of daily payment for labor. Professor Arbel believes that this transition would “spare employees the indignities of the payday, increase consumer liquidity, enhance worker autonomy, reduce the size of the payday lending industry, and improve the American economy as a whole.” Whether this is true on a large, meaningful scale remains to be seen. Nevertheless, one can reasonably surmise that a wholesale transition to a system of daily payment would have significant consequences, intended and unintended, on businesses and society. It will certainly make lives easier for many workers, but it could also have a significant impact on savings rates, consumption habits, and numerous other ripple effects on our current socioeconomic order.
The transition that is being advocated by Professor Arbel is not as radical as it may seem at initial glance. This transition is actually happening already. As more and more people take on nontraditional jobs in the gig economy, we are witnessing how work, wages, and payment practices have changed as a result of technology. Lyft drivers, Instacart shoppers, Grubhub delivery persons, and many other workers in the modern economy are already being paid on timelines that deviate greatly from the traditional monthly or biweekly payday timeline.
These unfolding business and labor changes have happened not because of law, but in spite of it. In fact, many of these new disruptive and innovative business and labor practices happened due to gaps and lags in the law relative to emerging new technology. In the financial sector, it can sometimes seem like laws, rules, and regulations—even well-intentioned ones—are trapped in a time where smartphones, apps, and electronic commerce simply do not exist. Policymakers need to do better to ensure that our financial and business regulations reflect the current technological and commercial realities of our world. New technology and new business practices can only do so much when constrained by outdated and mismatched rules and regulations.
In the coming months and years, cities and states will gradually reopen and rebuild with the specter of tens of millions of Americans unemployed and underemployed, all seeking a better payday. Much about how we work has changed as a result of the pandemic, and much will change as part of a grand but hard reopening and rebuilding. We need not go back to normal, however old or new. Entrepreneurs, executives, and employees can collectively work together to build better labor and business practices. In the end, while much remains unclear and uncertain about the road ahead, Professor Arbel’s article helps illuminate one possible better path for reimagining how we work, and also how and when we are paid for our work.
Cite as: Tom C.W. Lin, A New Payday(s)
(July 23, 2020) (reviewing Yonathan A. Arbel, Payday, 96 Wash. U.L. Rev.
1 (forthcoming 2020), available at SSRN), https://corp.jotwell.com/a-new-paydays/
Luca Enriques, Alessandro Romano & Thom Wetzer, Network-Sensitive Financial Regulation
, 45 J. Corp. L.
__ (forthcoming, 2020), available at SSRN
It is difficult to know what wisdom from pre-pandemic times will carry forward. One thing that feels very relevant, however, is the notion of applying network-sensitive approaches to regulatory structures that previously were atomistic in orientation. COVID-19 (the global emergency, not the virus) is nothing if not the product of global networks.
It takes some time for the full impact of a new paradigm to be realized. Those of us who have followed the systemic risk literature over the last decade or more will, I think, recognize in “Network-Sensitive Financial Regulation” a more comprehensive embrace of network theory than we have seen so far. Post-crisis recognition of systemically important financial institutions, or SIFIs, has always been somewhat awkwardly bolted onto existing regulatory structures. This is an exceptional article, because it represents a genuine step change in our thinking. It convincingly demonstrates how we might better incorporate network awareness into systemic risk analysis and macroprudential regulation, and then extends its insights further, to the micro level of corporate governance.
Our understanding of how networks operate in financial systems is relatively new. In modelling the financial crisis that started in 2007/2008, we learned a great deal about how risk was transmitted from one institution to another, and how in some cases it ramified into full-fledged systemic risk. With the benefit of hindsight we also recognized the moral hazard that had flowed from certain financial institutions being too big, or too interconnected, to fail: they had to be bailed out for the sake of systemic stability, but that meant that directors, officers, and shareholders of TBTF/TICTF firms were relatively immune to the downsides of the firm’s excessive risk-taking.
“Network Sensitive Financial Regulation” is a mature and compellingly-argued outgrowth of those experiences. Luca Enriques’, Alessandro Romano’s, and Thom Wetzer’s key argument is that “the transition to a regulatory regime that can effectively mitigate systemic risk in the modern highly connected economy will not be complete until financial regulation fully accounts for the structure of the financial network and the interconnections between its components” (P. 4.) Moreover, because of the torque that a firm’s systemic significance can have on normal corporate governance assumptions, network theory also has a contribution to make in the governance domain.
The authors provide a brief and useful history of how financial regulation progressed from the atomistic microprudential concerns of the pre-crisis era, which generated collective action problems and procyclicality, to the macroprudential concerns that governed especially SIFI regulation post-crisis. This much is familiar. From there, in a fresh move, the authors point out that a good deal of post-crisis macroprudential regulation – such as SIFI designations based on a financial institution’s asset size, whether $50bn or $250bn – still operates in a basically atomistic way. (It makes matters worse if regulation is based on binary SIFI/non-SIFI thresholds and bright lines, rather than institution-specific risk assessments.) Sometimes, the atomism is a function of how regulations are written. At other times, potentially network-sensitive methods nevertheless end up being operationalized atomistically.
Consider, for example, interconnectedness. Enriques et al. describe the fundamental concepts underlying network theory, such as nodes and centrality. In crude terms, the more central a financial institution is to a network, the greater its capacity to cause systemic harm. The authors also describe the ways in which different network typologies – mainly, more highly interconnected or looser ones – respond to larger and smaller shocks in different ways. By factoring in data about a firm’s centrality and the typology of the network it operates within, regulators could be in a position to calibrate, more directly, firms’ regulatory obligations to the systemic risk they present.
Instead, firm interconnectedness is commonly evaluated based only on the sum of a firm’s relevant exposures, as if those exposures had the same consequences regardless of the firm’s location within a network, or the network’s characteristics. Activity-based SIFI designations for non-banks, while an improvement on entity-based size thresholds, would also seem to fall into this category. These kinds of suboptimal implementation highlight the degree to which, even post-crisis, we have still not fully taken on board the value of network-level analysis.
One of the authors’ most provocative claims, however, is that just as macroprudential regulation can be made more effective through network-sensitive adaptations, so too can microprudential regulation – that is, corporate governance. Enriques et al. reject the idea that corporate governance rules, including the shareholder primacy norm, are atomistic by definition. When it comes to SIFIs in particular, corporate governance rules incentivize greater risk-taking, and growing the firm to become too big to fail (thereby enjoying a lower cost of financing and externalizing downside risks). In other words, the fact that a firm is systemically significant alters the incentives that would otherwise operate. This is, again, why the firm’s position within a network, and the network’s typology, matter. The authors illustrate this point by demonstrating how other new and interesting proposals around SIFI corporate governance – John Armour and Robert Gordon’s on directors’ and officers’ personal liability, Lucian Bebchuk and Holger Spamann’s on executive compensation, and Yair Listokin and Inho Mun’s on shareholder rights in shadow resolutions – can all be made more context-sensitive, more finely calibrated, and more effective by introducing meaningful network-level data about the firm’s position.
“Network-Sensitive Financial Regulation” reflects an important shift in the unit of analysis, from individual firm to network. It is because the authors have fully absorbed the importance of networks in financial systems that they are able to then roll those insights back to the governance context.
Networks may in fact be the concern of our age. Like internet hive mind rumors, like the pandemic, systemic risk indicators bring home how profoundly the health of our institutions depend on understanding the relationships between them. We were never islands, but nor have we ever been so interconnected. The time is ripe for the kind of paradigm shift that Enriques et al. propose here, in the context of financial regulation and corporate governance.
Editor’s Note: Christie Ford has asked us to to note that this jot was written and edited before the George Floyd and Black Lives Matter protests.
Cite as: Cristie Ford, We’re All in This Together
(June 30, 2020) (reviewing Luca Enriques, Alessandro Romano & Thom Wetzer, Network-Sensitive Financial Regulation
, 45 J. Corp. L.
__ (forthcoming, 2020), available at SSRN), https://corp.jotwell.com/were-all-in-this-together/
Tom Baker, Uncertainty > Risk: Lessons for Legal Thought from the Insurance Runoff Market
, 61 B.C. L. Rev.
__ (forthcoming 2020), available at SSRN
The received wisdom is that insurance can function well in a world of “risk” – the determinable probability of loss — but that insurance can function only poorly, or not at all, in the face of “uncertainty” – the indeterminate probability of loss. This received wisdom colors a lot of thinking, and judicial decision-making, about any number of policy problems, perhaps most prominently about the proper scope of tort liability. If the threat of liability cannot be reduced to a particular probability, the thinking goes, then it will be difficult or impossible to insure against, and part of the point of tort liability, to encourage spreading the risk of loss, will be undermined.
Tom Baker has pioneered the use of qualitative empirical research to shed light on issues in torts, insurance, and insurance law. In this Article, he employs empirical research to call into question the received wisdom regarding the capacity of insurance to function in the face of uncertainty. In an impressive combination of thick description and theoretical insight, he shows how the phenomenon of the insurance “runoff” has been able to function, with increasing frequency and effectiveness, despite the fact that its fundamental purpose is to insure uncertain probabilities of loss.
An insurance “runoff” occurs when an insurer ceases selling insurance and remains in business only to pay claims under previously-sold policies. Baker explains how, in the past several decades, responsibilities for some of the most severe and uncertain insurance exposures, such asbestos and environmental cleanup liabilities, have been transferred by the companies responsible for them in the first instance to runoff entities whose reason for being is to assume these uncertain exposures, for a price. In effect, the runoff entity insures the original company against highly uncertain liability.
In 1996, Lloyds of London created a runoff entity (“Equitas”) to assume its syndicates’ liabilities under past policies, which had long-tail exposure to asbestos, environmental cleanup, toxic tort, and products liability claims. And Warren Buffet’s Berkshire Hathaway owns a runoff company (NICO) that has engaged in Loss Portfolio Transfer (LPT) deals with insurance companies to function in a runoff fashion to liquidate liabilities under these portfolios. Apparently neither Lloyds nor Buffet has read the economics textbooks telling them that this won’t work.
But it has. Not only for Lloyds and Buffet, but also in life insurance, financial guarantee insurance, pensions and annuities, and long-term care insurance. Based on a series of field interviews and other research, Baker walks the reader through the mechanics of runoffs, explaining how a runoff entity engages in the underwriting, investment projection, and insurance policy claims management necessary to insure the uncertain exposure that it has assumed. This is legal sociology at its best, undercovering the actual economics of the runoff entity from the inside. It is impossible to read Baker’s account without being impressed, and maybe a bit frightened as well, by the way that the possibility of making a profit generated the ingenuity necessary to create the very institution of the runoff.
Baker ends by briefly assessing the public policy costs and benefits of runoffs, and comes out provisionally in their favor, all things considered. He argues that insurance is always dealing with one form of uncertainty or another, and that we should therefore jettison the ideal type of insurance as a risk-spreading entity, and substitute a paradigm of insurance as an uncertainty-management mechanism. Perhaps it would be better just to hold these two inconsistent ideas in our heads at the same time. Be that as it may, Baker has helped to shatter the received wisdom about the former idea, and brought the latter idea into the mainstream.
Cite as: Kenneth S. Abraham, Taking A Lesson From Uncertainty
(June 2, 2020) (reviewing Tom Baker, Uncertainty > Risk: Lessons for Legal Thought from the Insurance Runoff Market
, 61 B.C. L. Rev.
__ (forthcoming 2020), available at SSRN), https://corp.jotwell.com/taking-a-lesson-from-uncertainty/