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The Corporation as Regulatory Partition and the Veil Peeking Exception

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.

Cite as: Elizabeth Pollman, The Corporation as Regulatory Partition and the Veil Peeking Exception, JOTWELL (October 16, 2020) (reviewing Mariana Pargendler, Veil Peeking: The Corporation As a Nexus for Regulation, _ U. Pa. L. Rev. _ (forthcoming), available at SSRN),

Big New Problem Deflated

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, JOTWELL (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),

A New Payday(s)

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), JOTWELL (July 23, 2020) (reviewing Yonathan A. Arbel, Payday, 96 Wash. U.L. Rev. 1 (forthcoming 2020), available at SSRN),

We’re All in This Together

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, JOTWELL (June 30, 2020) (reviewing Luca Enriques, Alessandro Romano & Thom Wetzer, Network-Sensitive Financial Regulation, 45 J. Corp. L. __ (forthcoming, 2020), available at SSRN),

Taking A Lesson From Uncertainty

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, JOTWELL (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),

Corporate Law Can No Longer Ignore Shareholder Heterogeneity

Ann M. Lipton, Shareholder Divorce Court, 44 J. Corp. L. 297 (2019).

The shareholder base of modern U.S. public companies is diverse. At one end of the spectrum are large asset managers like BlackRock, which by itself has almost $7 trillion in assets under management. At the far other end are ordinary people—so-called “retail” investors. And between these two ends lie a hodgepodge of institutions, including public pension funds, hedge funds, insurance companies, and university endowments. Should corporate law assume that these shareholders all share a common goal?

According to Professor Ann Lipton’s timely and clear-eyed article, Shareholder Divorce Court, the answer is an emphatic “no.” While corporate law has traditionally elided the messy reality of shareholder heterogeneity by assuming that all types of shareholders have the same interest—wealth maximization—the landscape has changed. But as courts in recent years have adjusted and accommodated shareholder preferences that deviate from wealth maximization, they have created a new problem: smaller, less diversified shareholders may now be forced to accept suboptimal transactions that are not designed to promote their interests. Lipton’s account is important. In making her case and exploring how the right of appraisal can be reconfigured to act as a remedy, Lipton excavates yet another consequence of Delaware’s newfound confidence in the efficacy of the shareholder franchise.

As Lipton explains, corporate law traditionally “papered over” the problem of divergent shareholder preferences by entrusting directors, not shareholders, with most corporate decision-making and deferring to directors’ judgments. Nevertheless, under circumstances when the heterogeneous interests of shareholders were too blatant to ignore, courts stepped in to enforce the fiction that shareholders have a uniform preference for wealth maximization. For example, in vote-buying cases, courts have said that a bought vote becomes illegitimate when it does not “reflect rational, economic self-interest arguably common to all shareholders.”

The rise of large, sophisticated, and diversified institutional investors changed things. First, in Lipton’s telling, the “growth of institutional ownership has led to increasing—and increasingly visible—conflicts” between investors’ preferences. Institutional investors are now frequently invested in companies on both sides of a transaction, own both stock and debt in the same company, hold derivatives, and so forth—all of which give rise to idiosyncratic interests that are not shared by less diversified or retail shareholders.

Second, “[i]nstitutional investors’ size and sophistication puts significant strain on the doctrinal axiom that shareholders are too inexpert, or do not have sufficient incentives, to meaningfully contribute to corporate governance,” which had been the original justification for restricting shareholders’ power within the corporation. Recognizing this, the law evolved. Through cases like Kahn v. M&F Worldwide and Corwin v. KKR Financial Holdings, corporate doctrine has “shifted away from judicial enforcement of a fictionalized wealth-maximization norm, and toward accommodation of actual shareholder preferences.”

By connecting these two developments, Lipton deftly leads us to the problem she has identified. The law has moved toward allowing shareholders as a group to choose their own objectives—to choose to depart from maximizing wealth—but it continues to treat shareholders as a monolith, ignoring shareholder conflicts and the reality that certain types of shareholders are systematically more powerful than others. As it stands, the largest institutional investors may use their voting power to induce deals that advance their private interests at the expense of the interests of the corporation or its other shareholders. Smaller shareholders “whose interests do not align with those of the largest institutions” are now “left without an advocate,” and therefore may be “trapped in suboptimal transactions.”

This insight alone is a valuable contribution to the corporate law scholarship. But Lipton does not stop there—she concludes with an elegant solution to the problem using the right of appraisal. According to Lipton, past versions of appraisal had been used to manage shareholder heterogeneity, and appraisal today can be modified to serve its original purpose. Appraisal permits shareholders who dissent from certain actions to receive the appraised fair value of their shares. Lipton argues that a reformed appraisal can be a mechanism to ensure that institutional shareholders will, “in effect, pay other shareholders for the privilege” of inducing the corporation to pursue opportunities that sacrifice wealth maximization in favor of advancing idiosyncratic benefits. Appraisal, in other words, can allow shareholders to effectuate an amicable “divorce.”

Lipton’s works are often prescient, and this article is no exception. As she points out in the very first sentence, “Corporate law is designed to address conflicts of interests among stockholders and managers.” But a different type of conflict—inter-shareholder conflicts of interest—is now too obvious to ignore, so the law must adjust. Lipton’s article does an excellent job of launching this conversation.

Cite as: Da Lin, Corporate Law Can No Longer Ignore Shareholder Heterogeneity, JOTWELL (May 6, 2020) (reviewing Ann M. Lipton, Shareholder Divorce Court, 44 J. Corp. L. 297 (2019)),

From Group-Think to Thinking about Groups

Yuval Feldman, Adi Libson and Gideon Parchomovsky, Corporate Law for Good People, 115 Nw. U. L. Rev. (2020), available at SSRN.

Corporate law has incorporated some of the sociology of organizations. Often, this is by incorporating the concept of an organization having a culture. The organization’s culture organizes thought by individuals within the organization both by incorporating norms of satisficing and stimulating groupthink. In compliance, “tone at the top” is thought to be necessary. And, the concept of the organization shaping decisions within it explains why pervasiveness replaces mens rea for corporate criminal liability.

For many, organizational sociology is too vague. After all, in 1949, Clyde Kluckhohn demonstrated 73 different meanings that are attached to the concept of “culture.” Although the effects of organizations are apparent, the mechanisms by which organized experience frames individual decision-making are more difficult to understand. This is especially true in a culture, like ours, that prizes the self-determination of individuals.

Enter Corporate Law for Good People by Yuval Feldman, Adi Libson and Gideon Parchomovsky. Committed to methodological individualism, this essay explores individual behavior that is other-regarding and applies this psychology to corporate law. One of the pleasures of this article is its relentless adoption of one species of psychological analysis. It replaces the economically-rational individual with one whose self-interest incorporates a concern for others. The other genius of this article is its unflinching incorporation into corporate law of the results of this perspective.

For example, the authors suggest that board decision-making ought to adopt a “two-tier structure.” First, a single board member ought to make a decision about an issue. Not knowing how others would react, the single board member would be more free to consider the issue in all its complexity. The entire board would be presented with the single board member’s recommendation, but having a decision already made would lessen “the dishonesty that group deliberation generates” and potentially create dissonance with the norms of the board as a whole, thereby improving corporate decision-making. For the same reason, they criticize Van Gorkum’s reliance on lengthy deliberations in itself as a solution to problems of bias.

Psychology is brought to bear to answer the question: Why do people commit wrongs for the corporation even if it hurts themselves? The answer lies in understanding why people do things for their team that they wouldn’t do for themselves. To do that, the authors explore research that they label the field of “behavioral ethics,” although it actually is a subset of writing about the genesis of ethical (and non-ethical) behavior. The key finding of the research that they review is “that transgressions are easier to justify when they benefit other parties.” For example, a lawyer will act on behalf of her client in ways that they might deplore in others.

The article illuminates what has been forgotten in the Caremark line of cases. Chancellor Allen began with the question of board liability for “unconsidered inaction” and the Delaware Supreme Court ended with a rule of liability for failing to respond to red flags flying. In contrast to the Court, the article explores the “‘automatic’ mechanisms” that lead to unconsidered and unethical omissions.

The article then turns to consider situations in which the corporate actor wants “to be sensitive to the interests of others, and, in many cases, actually act according to those principles.” In these situations, sanctioning misconduct, without precisely defining what constitutes misconduct ex ante, will not deter because the actor has the conscious belief that they are in the right. Increasing vagueness in what is in others’ interest, such as replacing shareholder primacy with a stakeholder account, will only increase wrongdoing because it allows “agents more interpretive leeway that may be used to further their own self-interest,” although they consciously are pursuing the others’ interests.

Paying attention to the disjunction between conscious and less than conscious reasoning leads the authors to recast the understanding of “independence” in the context of board members and other professionals. Understanding oneself as “independent,” the authors conclude from psychological studies, “does not provide immunity against wrongdoing, but… may even entice wrongdoing by encouraging the agent to believe that she is immune from the influence of subtle conflict-of-interest[s].”

The authors justify imposing liability on the corporation for the actions of its agents because the agents are justifying their misconduct on the grounds that it is in the interests of the corporation. This is true even when the wrong-doing also personally benefits the wrong-doer because “there is a greater tendency to promote one’s self-interest when it also benefits others.”

On point after point, the authors have us reframe what we thought we knew about corporate behavior. They prove again and again what Louis Auchincloss knew when he told us that friendship in corporate life is often a way to later get the “friend” to do the unethical. But the authors take this insight into reconceiving corporate law.

As lawyers we know that we become vulnerable by taking on clients: We may forget our ethics in advancing client interests. The authors, however, emphasize that in asserting that our decisions are dominated by our clients, we also can hide to ourselves how we are pursuing our self-interests, such as running up the bill in order to better serve the client. We think of ourselves as “good people” but are being biased in ways that may serve ourselves more than our clients.

Although the article is full of insights, there is a cost in reducing sociological phenomena to individual ones. They praise requiring managers to certify that they didn’t manage earnings because it reframes “a passive behavior into an active one.” Perhaps, but many corporate cultures transform that certification into being understood only as “I trust my subordinates.”

There also is a cost in taking literature on bias in decision-making on behalf of others as constituting the field of “behavioral ethics.” First, even if we reduce ethics to “other-regarding actions,” that we can criticize these actions reveals that we have not subsumed ethics to these behaviors. Second, psychology has produced much more than an account of biases (and diseases). For example, positive psychology is not in evidence in this article. While professionals can hide to themselves how their supposed independence is working at the expense of their clients, professionalism also may augment dignity, bravery and persistence, habits of the heart that can stimulate ethical activity. Of course, these criticisms are beyond the scope of this article, so they do not lessen its own charm.

Cite as: Robert Rosen, From Group-Think to Thinking about Groups, JOTWELL (April 7, 2020) (reviewing Yuval Feldman, Adi Libson and Gideon Parchomovsky, Corporate Law for Good People, 115 Nw. U. L. Rev. (2020), available at SSRN),

History Lessons: Explaining the Origins of Corporate Charter Competition

Sarath Sanga, On the Origins of the Market for Corporate Law, available at SSRN.

Professor Sarath Sanga’s paper titled On the Origins of the Market of the Corporate Law is a thought provoking challenge to popular beliefs concerning the origins of the market for corporate law and state charter competition, that is: (1) Supreme Court jurisprudence helped create a national market for corporate charters; and (2) Delaware became a market leader only because New Jersey (the initial leader) repealed its liberal corporate laws in 1913.

Instead, the paper contends that these two popular claims are wrong. It offers an alternative explanation: organic industrial expansion and interstate commerce led to the emergence of the market for corporate law and that New Jersey declined as a market leader due, in part, to other states copying its laws.

Paper’s Central Findings

The paper contains an explanation of its methodology and data collection, so I will not focus on it here. (Pp. 12-17.) Instead, I will focus on the paper’s findings and the implications for scholars, firms, and policymakers. The first central claim is that Supreme Court jurisprudence, particularly the often-cited holding from Paul v. Virginia, did not set in motion the path to a national market for corporate law. Instead, the paper argues that Paul v. Virginia is “one in a long line of cases that opposed a national market and empowered states to discriminate against foreign corporations.” (Pp. 11-12.) Relying on historical sources and Supreme Court jurisprudence, the paper asserts that the Supreme Court did not promote a national market for corporate law. Instead, the Supreme Court throughout the 19th century and into the 20th century, regularly affirmed the states’ ability to discriminate against corporations with out-of-state, i.e., foreign charters. (P. 4.)

The second traditional claim the paper challenges is that New Jersey’s “Seven Sisters” regulation, repealing its liberal holding company statute in 1913, led to massive corporate migration, particularly to nearby Delaware. The paper relies on empirical evidence to show that New Jersey’s decline as the premier site of incorporation began shortly after 1903, nearly a decade before the “Seven Sisters” legislation and nearly seven years before Woodrow Wilson campaigned for governor in 1910. (P. 16.)

By the late 19th century, according to the paper, “the market for corporate charters was an accomplished fact.” (P. 18.) It contends that New Jersey’s liberal corporate statute, which long predated 1913, catalyzed greater migration to New Jersey by attracting foreign firms with “little or no connection to New Jersey.” (P. 19.) In essence, New Jersey’s early emergence as a leader in corporate charters is evidence of a somewhat competitive market for corporate law.

But if neither the 1913 Seven Sisters legislation nor Woodrow Wilson’s campaign for governor led to New Jersey’s decline, then what explains New Jersey’s earlier decline in the charter market? The paper maintains that basic competition from other states, copying New Jersey’s liberal pre-1913 corporate statute, explains New Jersey’s decline.

Paper’s Contribution to the Existing Body of Literature

Alternative Historical Account of New Jersey’s Decline

The paper supports an earlier timetable for the creation of a corporate law market and New Jersey’s decline as a premier site of incorporation. It maintains that the primary force behind the corporate law market was not necessarily a function of Supreme Court jurisprudence. Instead, it was a more organic process influenced by financial returns generated by firm expansion and multi-state operation. (P. 5.) Moreover, New Jersey’s preeminence was significantly undermined by jurisdictional competition and not solely due to the 1913 legislative changes.

Delaware’s Dominance and the Nature of Competitive Advantage

Although the paper deals primarily with New Jersey’s emergence and decline in the corporate chartering market, what does this narrative say about Delaware’s emergence and longstanding dominance? It suggests how a jurisdiction’s points of parity, such as statutory innovations that are easily replicated by other states, will not necessarily lead to sustained dominance. We should instead look to a jurisdiction’s points of differentiation, that is, its unique advantages, to account for sustained dominance in the charter market. Indirectly, the paper’s findings reinforce the body of literature suggesting some other factors besides law may account for Delaware’s sustained dominance in the corporate charter market, e.g., its court system, its brand, the preferences of corporate lawyers, and franchise taxes.

Paper’s Implications for Scholarly Debate and Future Research

Historical Trends Provide Valuable Context to Modern Debates

Whereas the paper addresses Supreme Court jurisprudence and New Jersey legislative developments at the turn of the 19th century, it simply acknowledges, but does not discuss, concomitant developments in other states like Delaware. According to some commentators, the provisions of Article IX of the 1897 Delaware State Constitution “radically changed the complexion of Delaware incorporation law and helped to propel Delaware to the position of corporate law pre-eminence that it occupies today.”1 Specifically, these state constitutional provisions abolished incorporation by special act and created a general incorporation act that had significant influence. Prior to this time, incorporations occurred primarily through special acts of the Delaware legislature and the average wait time was two years.2 Opponents of the special act procedure feared it inspired corporate “lobbyists” to exercise undue influence over Delaware politicians. As a consequence, Delaware established a general incorporation procedure as the exclusive method of incorporation for all Delaware entities (except for banks).3 Two years later, in 1899, Delaware adopted a comprehensive general incorporation law that, similar to other states, replicated aspects of New Jersey’s liberal corporate statute. Complementing a liberal corporate statute, Delaware adopted a franchise tax structure significantly more favorable than New Jersey’s.4 This parallel Delaware historical narrative complements the paper and its data by suggesting that Delaware’s ascendancy began earlier than New Jersey’s repeal of its liberal corporate statute in 2013. (Pp. 29-33.)

Modeling Incorporation Decisions

Incorporation decisions are not likely driven by a single variable. Perhaps it makes sense to view incorporation decisions akin to the purchase of a bundled product.5 Such an approach accommodates multiple contributing factors (e.g., regulatory environment, courts, and taxes) and may reconcile seemingly competing claims. From this vantagepoint, the interstate competition and firm expansion claim is consistent with New Jersey eventually being perceived as less competitive or in parity with other states, and Delaware emerging and sustaining its dominance through differentiation advantages.

In conclusion, Sanga’s paper is an insightful read for scholars interested in the origins of state charter competition and potentially its future.

  1. Randy J. Holland and Harvey Rubenstein, The Delaware Constitution of 1897: The First one-Hundred Years 159 (1997).
  2. Id. at 161.
  3. S. Samuel Arsht, A History of Delaware Corporation Law, 1 De. J. Corp. L. 1, 7 (1976).
  4. William E. Kirk III, A Case Study in Legislative Opportunism: How Delaware Used the Federal-State System to Attain Corporate Pre-eminence, 10 J. Corp L. 233, 254-55 (1984).
  5. Roberta M. Romano, Law as a Product: Some Pieces of the Incorporation Puzzle, 1 J. L. Econ. & Org. 225, 233-35 (1985).
Cite as: Omari Simmons, History Lessons: Explaining the Origins of Corporate Charter Competition, JOTWELL (March 5, 2020) (reviewing Sarath Sanga, On the Origins of the Market for Corporate Law, available at SSRN),

Dual Class Stock in Comparative Context

Marc T. Moore, Designing Dual Class Sunsets: The Case for a Transfer-Centered Approach, University College London Faculty of Laws Working Paper No. 9/2019, available at SSRN.

The optimal balance of power between shareholders and boards of directors in public companies remains one of the most consequential and contested issues in corporate governance, and the debate has only intensified as share ownership has become more concentrated in the United States and U.S.-style shareholder activism has arisen in other capital markets around the world. Against this backdrop, as Marc Moore explores in the paper cited above, dual class stock (DCS) structures “have spread exponentially in recent years across much of America’s public company community,” and “certain jurisdictions that have traditionally been averse to permitting DCSs have come to recognize the potential benefits of taking a more permissive stance” – including Singapore and Hong Kong, two of the world’s most prominent financial centers. In his paper, Moore maps this complex terrain, providing a comparative analysis of various approaches to regulating DCS structures and calibrating associated incentives. Specifically, he focuses on “whether DCSs should be perpetual or rather should terminate (or ‘sunset’) at some point in time,” and “the most appropriate means of determining when and how time-limited DCSs should sunset.”

Moore observes that U.S. tolerance for DCS structures and associated deviation from the one share/one vote approach “would appear to be more international outlier rather than norm,” even relative to the United Kingdom where “London’s traditional capital market norms have proved considerably less tolerant in this regard.” Through a detailed discussion of extant literature, he contrasts proponents’ aim to give management “a degree of strategic breathing space … from the intense pressure exerted by quarterly financial reporting hurdles” with opponents’ concerns regarding various forms of controller agency costs borne by holders of low-voting stock.

Singapore and Hong Kong, however, have pursued intermediate approaches that point toward a spectrum of possibilities in DCS design. Both have recently liberalized their listing rules to permit DCS structures under certain circumstances as a means of attracting innovative high-tech companies, but only within specific regulatory parameters, which include sunsets. Notably, in both jurisdictions, multiple-vote shares generally convert to single-vote shares upon transfer. Meanwhile, alternative sunset models have been advocated, including ownership-based sunsets, under which conversion is generally triggered by multi-vote shareholders’ cash-flow interest in the company falling below a specified level (say, 10 percent), and time-based sunsets, under which conversion is generally triggered by passage of a specified period of time (say, 10 years). As Moore describes, the latter have increasingly been adopted, on a firm-by-firm basis, in the United States.

Acknowledging that “there are in practice a variety of general sunset models for investors, managers and (where relevant) regulators to choose from” along the foregoing lines, and “a wide range of specific potential triggers within each of those models” that might be adopted, Moore concludes that transfer-based models generally ought to be favored. Notably, Moore argues that “regulatory requirements for fixed-term sunsets calibrated on anything wider than a firm-specific basis are inherently arbitrary,” and that even firm-specific sunsets of this sort may prove undesirable because, “by their very nature, they are designed proactively a number of years ahead of their intended activation.” Ownership-based thresholds, requiring that a certain level of economic interest be maintained, may prove “less problematic” in this regard, yet are still “susceptible to the same charge of eliciting crude and factually insensitive outcomes” in so far as a founder or other controller may have “legitimate prudential motivations for wishing to liquidate part of her multi-vote holding.” Having to forego such flexibility might “increase the relevant firm’s cost of raising fresh equity capital from prospective future controllers.”

The transfer-based approach adopted by Singapore and Hong Kong, on the other hand, generally “will only be triggered by the death or retirement (as a director) of the multi-vote holder(s), or the sale of her equity stake,” which “insures against the risk of disturbance to the firm’s pre-existing business trajectory.” By the same token, Moore observes that since a transfer of control “entails a sudden change of trajectory for the firm’s business (whether strategically or at least culturally) in any event, it follows that conversion of the firm’s capital structure at this point in time will not in itself be a likely cause of organizational destabilization.” Based on these and other considerations, Moore suggests that U.S. regulatory authorities “give serious consideration to adopting the transfer-centered model of sunset regulation that has recently been implemented by the Hong Kong and Singaporean exchanges, as a more moderate alternative” to the time-based approach that institutional investors have advocated.

Moore’s comparative framework brings analytic clarity to a rapidly evolving set of corporate governance issues, while raising important normative and empirical questions for future research. For example, given the general arguments against DCS structures, perhaps there is a reasonable normative case to make for U.S. adoption of a moderate brake on their use, as Moore’s analysis suggests. Conversely, however, given the general arguments in favor of DCS structures, perhaps there is likewise a reasonable normative case to make for moderate liberalization of the U.K. approach, departing from London’s historically “less tolerant” position in the other direction. By the same token, the intermediate approaches recently adopted by Singapore and Hong Kong may or may not, as an empirical matter, strike the stable balance desired. Should they prove unworkable, or otherwise be disfavored by an increasingly globalized marketplace, this might re-focus attention on the more extreme approaches, in one direction or the other, or some new approach entirely – time will tell. Regardless, Moore’s framework provides a nuanced and insightful guide to the issues, and a clear lens through which to assess future developments in this dynamic area of corporate governance.

Cite as: Christopher M. Bruner, Dual Class Stock in Comparative Context, JOTWELL (February 12, 2020) (reviewing Marc T. Moore, Designing Dual Class Sunsets: The Case for a Transfer-Centered Approach, University College London Faculty of Laws Working Paper No. 9/2019, available at SSRN),

Parallel Universe Defaults

Gina-Gail Fletcher, Engineered Credit Default Swaps: Innovative or Manipulative?, NYU L. Rev. (2019).

Credit Default Swaps (CDS), like banks, are mind-blowingly simple and potent credit replication machines. Banks replicate their own credit—conjuring gobs of money out of thin air—with a license and a convoluted web of guarantees from the state. CDS can replicate anyone’s credit, with industry-coordinated standard contracts embedded in a tangle of carve-outs, safe harbors, and exemptions from statutes and regulations. The 2007-2009 financial crisis brought a heap of bad press and new regulatory requirements for CDS dealers and trading infrastructure, but did not fundamentally alter the contractual governance paradigm at the heart of this multi-trillion dollar market.

Opportunistic or downright slimy behavior in a space so carefully shielded from substantive regulation can be hard to diagnose, even when it poses an existential threat to the CDS market and could spill beyond it. Recent reports of bad behavior have prompted high-profile lawsuits, contract reforms, and a crop of law review articles revisiting contractual, statutory, and regulatory ecosystems for CDS.

The range of approaches reflects the multifaceted challenge, but can be confusing. Gina-Gail Fletcher’s analysis in Engineered Credit Default Swaps: Innovative or Manipulative? is thoughtful, comprehensive, and a good place to start.

Loaves, Fishes, and Freedom of Contract

Suppose Creditor Cindy Corp. buys $100 million in bonds issued by Borrower Ben, due a year hence, with a $3 million interest payment due in six months. At the other end of the galaxy, Trader Joe—a stranger to Cindy and Ben—bets that Ben is broke. Another stranger, Dealer Dave, takes the opposite side of the bet. He offers to pay Joe $100 million if Ben does not pay Cindy in full and on time, in exchange for a $3 million fee. If Joe accepts, he and Dave would be in a CDS contract on Ben (the “reference entity”), where Joe is a “protection buyer” and Dave a “protection seller.”

If Ben repays Cindy as promised, Dave earns $3 million, just like Cindy. If Ben defaults at the end of the year, Dave loses $100 million, less $3 million, just like Cindy.

The new CDS contract doubles the galaxy’s exposure to Ben’s credit. Absent regulatory constraints, any two counterparties willing to take opposite sides in a bet on Ben’s credit could do the same as many times as they wish. Losses from a Ben default could keep multiplying in distant corners of the galaxy entirely unconnected to Ben or Cindy.1

Parallel Universe

CDS terms need not track Ben’s original debt contract precisely. Joe and Dave might have a contract for six months (through Ben’s interest payment), or for half the notional principal amount. Because CDS isolate and transfer credit risk, the list of “credit events” that may trigger Dave’s obligation to pay Joe differs from the “events of default” in Ben’s contract with Cindy. The CDS would also ignore Cindy’s actual response to Ben’s distress: the bet is on Ben’s condition, not on Cindy’s risk management.

For instance, if Ben’s interest payment is a few days late, Cindy might let it go if she knows Ben is good for the money, but Dave would still have to pay Joe. If Ben hits a rough patch, he and Cindy might amend their contract to postpone the maturity date, avoiding default to Cindy—but not Dave’s obligation to pay Joe. If Ben files for bankruptcy protection, it would stay Cindy’s claim on Ben, but not Joe’s claim on Dave.

Joe and Dave inhabit a parallel Ben-credit universe, simplified and abstracted from Ben’s real-world relationship with Cindy. Ben’s business problems can affect Joe, Dave, and other perfect strangers elsewhere in the galaxy in ways that are neither visible nor manageable under the Ben-Cindy contract.

Contract Rule

Trader Joe and Dealer Dave do not write their CDS contract from scratch. ISDA, the derivatives industry association, has produced standard terms for CDS and other derivatives since the 1990s, leaving the parties to customize a limited set of relationship- and transaction-specific items. ISDA also works with governments and lawyers around the world to ensure that its contracts are enforceable everywhere. Robust industry-coordinated standardization often gets credit for derivatives market liquidity.

Keeping regulators at bay remains an important part of ISDA’s work. To succeed, it must foster public faith in the industry’s capacity to regulate itself: preventing and mitigating market disruptions, responding to shocks, and adapting contracts and market practice to new circumstances. To that end, ISDA has taken on new functions over time. It has established an auction procedure to calculate payouts, and a limited adjudication mechanism in the form of industry-staffed regional “Determinations Committees,” which decide whether a CDS credit event has occurred.

The result is a peculiar ecosystem. The same mechanisms that help the industry adapt and respond to shocks also risk transmitting hiccups in any given bilateral relationship or seemingly isolated contract interpretation to distant markets and otherwise-unrelated firms.

Knaves in Loopholes

ISDA’s CDS contract interpretation posture tends to the formal end of the spectrum. In most cases, Determinations Committee decisions have stuck to plain meaning and the four corners of the contract. This approach is at least intuitively consistent with the emphasis on market liquidity: importing relational context in an arm’s length wager could make it hard to trade.

On the flip side, a commitment to narrow textual reading creates arbitrage opportunities, or worse, invites behavior that is patently inconsistent with the spirit of the CDS contract and its market function.

Enter Hovnanian, a home building firm, and GSO Capital Partners, a hedge fund affiliate of the Blackstone Group. In 2017, GSO offered to refinance Hovnanian’s debt on below-market terms, provided Hovnanian borrowed just over $1 million from its own subsidiary and briefly defaulted on an interest payment. The late payment was enough to trigger more than $330 million in CDS that GSO had bought from another hedge fund, Solus, and Goldman Sachs, but not enough to harm the builder’s credit otherwise. Under ISDA’s auction rules, the debt to Hovnanian’s subsidiary also helped inflate the payout to GSO. Solus lobbied ISDA, made a public stink about GSO’s slimy ways (it had pulled a similar trick in 2013), sued, and settled in 2018.

So What?

In the end, Hovnanian got cheaper funding and GSO might have made a bundle off another hedge fund. In the words of one prominent commentator, the incident might have threatened the “integrity and viability of the CDS market,” but had no serious “real world” (read real economy) consequences. Who cares?

Fletcher’s article does a lovely job wading through the thicket of pros and cons to answer this question. The cons come out ahead precisely because she takes CDS to be valuable as a source of market liquidity. If CDS contracts detach from the underlying credit risk and become bets on the likelihood of collusion between the reference entity and a CDS counterparty (in the manner of insurance fraud, minus insurance regulation), they lose value for CDS and credit market liquidity, price discovery, and credit access.

The article’s typology of “engineered CDS”—miscreant behavior involving CDS counterparties and the reference entity—covers Hovnanian-style “manufactured” defaults driven by protection buyers, as well as protection seller schemes to kick default just beyond the CDS contract term, or to frustrate the point of a CDS contract by moving all debt from the reference entity to its subsidiary. In all three transaction types, the trouble starts in the CDS parallel universe; smoke may drift into the real world, but the harm is uncertain and would be hard to ascertain empirically. 2

To the extent these arrangements are harmful, Fletcher’s doctrinal analysis is especially worthwhile for illustrating the breadth and interdependence of contractual, statutory, and regulatory maneuvers shielding CDS contracts from government intervention. Express contract terms and recent court decisions virtually foreclose arguments about good faith, while the SEC and CFTC jurisprudence make it hard to prove manipulation, particularly where the existence of engineered transactions is widely known and baked into CDS prices. This might explain why the SEC and the CFTC have limited themselves to censorious press statements.

Meanwhile, ISDA has tweaked its contracts again, putting more stock in adjudication and Determinations Committees’ judgment. The Determination Committees now have the authority to distinguish between credit events stemming from credit deterioration and those (engineered ones) detached from it.

I share Fletcher’s skepticism of Determination Committees’s capacity to lean into this new authority; I also suspect it is as good as it gets. Instead of investing in ISDA’s already strained adjudication apparatus, I might prefer to revive good faith3 (the article offers two ways to go about it) and, even less plausibly, a return to public adjudication. Generalist judges might get it wrong sometimes, but the derivatives industry is better equipped than most to compensate for judicial missteps. Shielding it from inexpert scrutiny has not made the public more informed or more sympathetic, and has hardly been good for its own health.

  1. If Creditor Cindy takes such a bet once, she would not create net new exposure to Ben—all else equal, buying a CDS contract on Ben from Dealer Dave would simply transfer Cindy exposure to Dave. However, nothing prevents Cindy from buying three or ten CDS contracts, which would create net two or nine new bets on Ben.
  2. Other authors situate the Hovnanian caper in different taxonomies. Henry Hu focuses on information asymmetries on the eve of bankruptcy, and the behavior of “net short” creditors with complex incentives in a thoroughly opaque market (more disclosure is indicated). Ted Janger and Adam Levitin cite the incident in their analysis of economic and governance rights decoupling in and out of bankruptcy. Robert Rasmussen and Michael Simkovic discuss it as an instance of flawed contract drafting and opportunism, upending counterparty expectations despite abiding by the letter of the contract. They propose to pay bounties to non-parties for identifying contract flaws. Their exposition is excellent; however, the challenge of telling contract flaws apart from ordinary contract incompleteness strikes me as formidable.
  3. Reading Fletcher alongside this recent account of distressed debt shenanigans and pitch for good faith makes me think that reviving the doctrine could be a useful check on financial engineering abuses beyond CDS.
Cite as: Anna Gelpern, Parallel Universe Defaults, JOTWELL (January 27, 2020) (reviewing Gina-Gail Fletcher, Engineered Credit Default Swaps: Innovative or Manipulative?, NYU L. Rev. (2019)),