Jun 30, 2023 Joan MacLeod Heminway
Public company law and practices in the United States are rooted in line-item and gap-filling disclosure regulation. Although the precise place and value of disclosure in business law and regulation has been—and (appropriately) continues to be—debated, mandatory disclosure has been a cornerstone of the U.S. federal securities laws applying to public companies since the enactment of the Securities Act of 1933. Together with liability (including antifraud) provisions and substantive regulation, mandatory disclosure rules have been one of the three core regulatory tools employed at the federal level to promote capital formation and fair, honest markets for securities, while at the same time providing core protections for investors.
At its core, Lisa Fairfax’s Dynamic Disclosure: An Exposé on the Mythical Divide Between Voluntary and Mandatory ESG Disclosure embraces mandatory disclosure rules in the spirit in which they have been enacted and employed in U.S. federal securities regulation. The article also, however, articulates the independent and cooperative value of voluntary disclosure as an important piece of the regulatory puzzle. In essence, Fairfax suggests that “the modern publicness of corporate information has eroded the walls between voluntary and mandated disclosure, making it impossible not to consider voluntary disclosure as an integral aspect of mandated disclosure and the overall disclosure regime in which corporations operate.” Importantly, Fairfax illustrates this proposition in the context of one of the most hotly contended areas of current regulatory debate: ESG (environmental, social, and governance) disclosures, including the U.S. Securities and Exchange Commission’s climate change disclosure proposal. Her insightful and diplomatic treatment of the subject matter is a breath of fresh air in ongoing debates about both the regulation of ESG disclosures specifically and mandatory disclosure as a component of securities regulation more generally.
Dynamic Disclosure first offers background on the SEC’s climate change proposal as part of the overall history and usage of mandatory disclosure in U.S federal securities regulation. It then proceeds to outline the debate between and among the proposal’s supporters and detractors and to offer an alternative perspective on the debate, essentially embracing points made by both sides. Fairfax supports her thesis with theory and matter-of-fact reasoning, citing to a wide variety of sources.
Along the way, she also treats us to a clear and cogent primer on ESG disclosures. She is careful to note the foundational roles played by line-item and gap-filling mandatory disclosure rules that already compel the disclosure of ESG information in certain settings. Especially important in this regard are the disclosure requirements adopted by the U.S. Securities and Exchange Commission in Item 303 of Regulation S-K and the gap-filling mandatory disclosure rules in Rule 408 under the Securities Act of 1933 and Rule 12b-20 under the Securities Exchange Act of 1934. Interestingly, Fairfax does not mention in this same breath the overall disclosure nudge that potential liability under Section 10(b) of and Rule 10b-5 under the 1934 Act provide in compelling ESG disclosures (although she later notes that Section 10(b) encourages the production of accurate and complete disclosures).
I most enjoyed Part III of Dynamic Disclosure, in which Fairfax makes her case for dynamic disclosure—the naturally amicable coexistence of voluntary disclosure and mandatory disclosure. This part of the article also usefully communicates four benefits of voluntary disclosure: flexibility as to content and timing; the provision of a laboratory for disclosure experimentation; accessibility/digestibility; and adaptability/timeliness. Finally, before addressing a few possible remaining concerns about dynamic disclosure (possible disclosure overload, a lack of comparability, and the potential for inaccuracies), Part III illustrates the characteristically interconnected nature of voluntary and mandatory disclosure.
Fairfax indicates that her work in Dynamic Disclosure “seeks to shift the disclosure debate away from a binary choice between mandatory and voluntary disclosure.” The article skillfully serves that purpose. Indeed, it is inspirational—and illuminating—to read legal scholarship that is not advocating a sterile, exclusive solution in a my-way-or-the-highway manner. Fairfax’s thesis and analysis are refreshingly nuanced and pragmatic, and she illuminates an important topic. Good legal scholarship doesn’t get much better than that.
May 30, 2023 Da Lin
Professors Jeremy Kress and Matthew Turk’s warning that “too-big-to-fail” megabanks are not the only source of systemic risk to the banking system has proved prescient. Shortly before its collapse on March 10, 2023, Silicon Valley Bank (SVB) had approximately $209 billion in total assets. SVB was the sixteenth largest bank in the U.S., but it still fell below the size threshold that automatically triggered an enhanced regulatory regime. Until it failed, SVB was not regulated as a “systemically important” bank because it was not big enough. Yet two days after it closed, federal regulators invoked the “systemic risk exception” after determining that they needed to rescue the uninsured depositors of SVB and the even-smaller Signature Bank to prevent destabilizing the broader financial sector.
In Too Many to Fail: Against Community Bank Deregulation, Kress and Turk foreshadow the error of equating “systemically important” with “too-big-to-fail.” The article is an incisive response to the sweeping efforts since 2010 to ease the regulatory burden on small and midsize banks, which culminated in the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. It argues that this deregulatory push has been premised on three widely held but mistaken myths: (1) smaller banks cannot propagate systemic risk; (2) post-financial crisis reforms overly burdened smaller banks; and (3) smaller banks require special regulatory relief or advantages to compete with too-big-to-fail counterparts.
Kress and Turk make this argument in its most expansive sense, by focusing not on banks that fall just below the “systemically important” cutoff, like SVB, but rather on the smallest depository institutions: so-called community banks with less than $10 billion in assets. But even those who are unpersuaded by the full scope of their claims will agree with many of their broader insights about why smaller banks merit serious regulatory attention.
Too Many to Fail starts by establishing that the community banking sector can propagate systemic risk. In broad strokes, systemic risk exists because community banks tend to have highly correlated balance sheets and funding vulnerabilities. Because runs can spread rapidly between institutions with similar profiles, the community banking sector is particularly susceptible to concurrent failures. And a collapse of community banks en masse could well distort capital markets and disrupt the real economy. The systemic impact of small bank runs is not a mere theoretical possibility: according to the authors, the simultaneous failure of many small banks was a component of every banking crisis in American history, including 2008.
Kress and Turk next consider how systemic risk from the community banking sector ought to be regulated. Using the Dodd-Frank Act and other post-financial crisis reforms as the baseline, Kress and Turk seek to dispel the persistent concern that the regulatory framework since 2010 has been uniquely onerous for community banks. They document the ways in which policymakers “made special efforts” to design postcrisis rules to limit the regulatory burden on smaller banks and provide them with both explicit and implicit subsidies, such as reducing their contributions to the Deposit Insurance Fund, exempting banks with less than $10 billion in assets from the cap on debit card transaction fees, and curtailing the ways in which the largest banks can use their size to gain competitive advantages. On balance, they calculate, “[these accommodations] likely offset the financial drag from new prudential regulations imposed on community banks after the crisis.”
Kress and Turk’s final claim is the most expansive: community bank regulatory relief is ill advised not only because the postcrisis status quo was not excessively burdensome for community banks, but also because “community banks do not necessitate special legal treatment,” either in the form of deregulation or subsidies. In their view, regulatory advantages or relief for community banks will not meaningfully impact the current concentration of financial assets in too-big-to-fail banks, increase the availability of credit for local communities or nontraditional borrowers, or supply a necessary correction to an uneven playing field between the largest and smallest banking institutions.
There is a lot to be gained from this article, especially in the current moment. SVB’s collapse put the broader financial system at risk through the linkages that Kress and Turk describe: as word of SVB’s problems spread, other midsize banks that shared similar risk, funding, and geographic profiles began to experience significant deposit withdrawals. Signature Bank, which closed two days after SVB, reportedly lost 20% of its total deposits in a matter of hours after SVB failed. Kress and Turk’s warning that a two-tiered treatment of large and small banks could inadvertently drive risk-taking toward the less regulated sector also deserves close study, particularly in light of growing concern over smaller banks’ exposures to the turbulent cryptocurrency industry. And besides recommending the obvious conclusion of rolling back recent deregulatory initiatives, Kress and Turk also offer several practical proposals for reform, including stress tests of smaller banking sectors as a whole to identify and prevent the build-up of common vulnerabilities.
Naturally, there are also grounds for challenging some of the article’s claims. For example, do community and midsize banks, on the one hand, and the largest banking conglomerates, on the other, propagate systemic risk in different ways that require different rules? Do other distinctions between their operating models necessitate giving smaller banks some regulatory relief or subsidy? Kress and Turk document that community banks have profitably co-existed with the largest banks since 2010, but community banks were arguably only able to compete effectively because they received special legal treatment within the postcrisis framework.
There have already been numerous calls for regulatory changes since SVB’s and Signature Bank’s collapse. Too Many to Fail’s clear-eyed distillation of how smaller banks can create important systemic risks to the financial system and how those risks ought to be regulated provides a timely, important starting point for any conversation about banking reform.
Mar 27, 2023 Robert Rosen
Jillian Grennan & Kai Li,
Corporate Culture: A Review and Directions for Future Research in Handbook of Financial Decision Making (Gilles Hilary & David McLean eds., forthcoming 2023), April 28, 2022 draft available at
SSRN.
In the 2022 Annual Review of Financial Economics, Jillian Grennan, with lead author Gary B. Gorton and Alexander K. Stentefis, document studies by economists that use “corporate culture” to explain M & A choices and consequences, individual and business risk-taking, as well as corporate malfeasance. Such research has been propelled by new data sets and methods. For example, employee grievances and networks are now revealed on the web and natural language processing now translates texts into cultural elements. Work in this mode also emerges because much remains to be explained about corporate decisions after the usual analysis under the property rights and agency cost paradigms. Grennan and her co-authors propose corporate culture as a new “theoretical paradigm” for corporate finance research.
The problem with this paradigm, as the authors note is that “culture” is an “omnibus term.” Unpacked, it includes “values, norms, conventions, shared beliefs, customs, traditions, symbols, rituals, knowledge, identity, ideologies, identities, and shared mental models.” Corporate culture includes everything from employee perceptions of managers’ ethics (positively associated with Tobin’s Q) to stock options for rank-and-file employees (positively correlated with financial misreporting). Mathematical representations of corporate culture are few in number. We have measurements of company reputations, homogeneous beliefs across the company, and managerial preferences. But these tell us little. Researchers have shown us that “employees’ firsthand impressions of the manager’s instructions, along with their secondhand interpretations from communicating with each other about the manager’s instructions, together shift the observed culture away from the manager’s intended one.” Furthermore, there also is “within-person cultural diversity”–individuals believe contradictory things. Consequently, despite reviewing research that finds correlations between “cultural” changes and financial decisions, the authors call for “More theoretical work on corporate culture.”
Fortunately, Jillian Grennan takes steps to developing such a theory in her book chapter with Kai Lin, Corporate Culture: A Review and Directions for Future Research. They begin by noting that in the 1950’s, anthropologists assembled a list of 164 different definitions of societal culture. They draw on sociological theory to describe culture as part of the informal institutional structure of firms. They understand that culture has two faces: meaning-creating and behavioral patterning. The expectations employees have about “how they need to behave to fit in and succeed in their firm” are part of corporate culture. Changes in such expectations are then studied to understand the dynamics of corporate culture.
In society, culture often is relatively stable and of uncertain value. Businesses, however, can train meanings and audit actions. In so doing, they intentionally try to modify how employees behave. Although intangible, changes in culture can be relevant and add value. By providing meanings and valorizing expectations, culture helps define employee preferences and pattern behavior.
In society, culture often refers to broadly shared structures of meaning and action. In contrast, in firms, both small and large, behavior is not explained by looking for an overarching culture, such as the tone set by those at the top. Cultural diversity is what employees experience. Ethnic ancestry, familial and other commitments, as well as specific experiences all influence what employees find meaningful and what they take as routine. Joining a project team, for example, brings about cultural changes both for the joiner and the rest of the team but these changes and their effects will vary depending on the experiences that the employees had on other project teams. On the other hand, in firms, stories can spread like wildfires and certain memes may be required in all communications.
Because corporate culture can be intentionally created and is limited in its reach, it enables marginal analysis. The sources of cultural change are broad, including people, systems, and events. The authors propose analysis of catalysts of cultural change and their effects to further develop theories of corporate culture.
Behavioral economics explores the borders between rational and irrational preferences. Cultural analysis explores what is meaningful. Cultures shape how rationalities, in their various forms, are valued. Cultural analysis thus explores the borders between rational and meaningful preferences to explain decision making.
Research on corporate culture has explored the meanings of integrity, trust, adaptability, cultural flexibility, collaboration, teamwork, hard work, mastery, innovation, confidence, respect, quality, safety, consumer-orientation, detail-orientation, results-orientation, community, communication, transparency, corruption avoidance, pro-social (ESG) values, individualism, gender, risk-taking, uncertainty avoidance, and time-framing. Developing a larger theory from this research, however, is hampered by differences in defining each of these terms. Unfortunately, the idiosyncratic nature of culture, as well as the multiplicity of catalysts of change, stand in the way of any global theory of corporate culture.
Understanding that firms are not values melting pots and that different meanings are operative on their own terms as well as in conjunction with other cultural elements complicate intentional changes of corporate culture. Such changes are mandated in many settlements of corporate non-compliance lawsuits. Deferred- and Non- Prosecution Agreements (DPAs and NPAs) presume, as do Grennan and Li, that “culture guides employees’ actions.” What Greenan and Li importantly add is that it is often “difficult to decipher the cultural meaning of what is observed.”
Like most teachers, I understand that shouting at the beginning of class “Stop Talking” won’t produce the desired result. Yet, most DPAs assume that when corporate leaders say “Stop Non-complying” compliance will follow. Before you next rely on “tone at the top” to set a corporate agenda, I recommend reading this book chapter.
Cite as: Robert Rosen,
Corporate Culture is Complicated, JOTWELL
(March 27, 2023) (reviewing Jillian Grennan & Kai Li,
Corporate Culture: A Review and Directions for Future Research in Handbook of Financial Decision Making (Gilles Hilary & David McLean eds., forthcoming 2023), April 28, 2022 draft available at SSRN),
https://corp.jotwell.com/corporate-culture-is-complicated/.
Feb 16, 2023 Omari Simmons
Atinuke O. Adediran,
Disclosing Corporate Diversity, 109
Virginia L. Rev. __ (forthcoming 2023), available at
SSRN.
Atinuke Adediran’s insightful article, Disclosing Corporate Diversity, advances the contemporary discussion by examining the legacy and limitations of extant and proposed corporate diversity disclosure approaches. She proposes an alternative diversity disclosure regime based on more comprehensive statistical and forward-looking elements to inspire tangible changes.
Over 50 years ago, Ralph Nader and a group of Washington lawyers challenged General Motors Company (GM) over such critical concerns as product safety, environmental impact, and diversity. The 1970 Project on Corporate Responsibility sought shareholder approval of several resolutions. One would have expanded the board to include three directors nominated by constituent groups of employees and consumers. Another would have required GM to publish information on its auto safety, pollution control, and minority hiring policies.
This campaign followed the social upheaval of the late 1960s: the assassinations of Martin Luther King Jr. and Robert Kennedy, riots and fires that devastated US urban centers, recession and deep skepticism about leadership generated by the Viet Nam War. In response to this confluence of events and pressures, GM Chair and CEO James Roche actively recruited Reverend Leon H. Sullivan to join the GM board of directors, and in 1971, Sullivan became the first Black person to serve on the board of a major US public company. He would serve on GM’s board for over twenty years.
Sullivan was a synergistic choice—a human capital expert with a multifaceted skill set—but it surprised many observers; as a civil rights activist, he had successfully organized boycotts to compel companies to change their discriminatory hiring practices. He soon moved beyond the antagonism of boycotts, collaborating with the private sector to develop a path-breaking vocational training program, Opportunities Industrial Centers, which created a pipeline for minorities, immigrants, Native Americans, and the poor. Envisioning a more inclusive free enterprise system, Sullivan worked to convince the federal government and large companies like GM to invest in people on the margins of society and to link corporate America’s success and growth to its ability to harness human potential, especially in inner cities. Since the 1970s, we have witnessed some progress on the broader front, yet diversity remains one of corporate America’s most complex and pressing deficiencies.
The Paper’s Central Findings and Claims
Historically, CSR/ESG (corporate social responsibility/environmental, social, and governance) disclosures mostly focused on companies’ environmental, community-based and philanthropic efforts with limited engagement with diversity. (P. 5.) Adediran shows that for the past five years, public companies have incorporated more diversity disclosures into their CSR/ESG reports. (Pp. 6, 22-30.)
The paper makes three central claims. First, disclosure can function as an instrument to prompt diversification of corporate boardrooms and workplaces. Second, diversity disclosures are important to a wider range of stakeholders than shareholders. Third, legislative reform is necessary for diversity disclosure effectiveness. (Pp. 3-4.) This review focuses largely on the third claim, in support of which Adediran examines the limitations of extant and proposed approaches to diversity disclosure and proposes potential enhancements.
Limitations of Extant Approaches
SEC/Nasdaq Diversity Disclosure Mandate. Adediran cites three shortcomings of the recent Nasdaq SEC-approved diversity disclosure mandate. First, the rule’s comply-or-explain approach requires companies merely to explain why they lack diversity and may not result in an increase. Second, the disclosures are limited to board diversity. The rule does not require diversity disclosures related to employees, executives, or managers, which are equally, if not more important according to academic research. Third, the scope of the rule’s application is too narrow, applying only to public companies listed on Nasdaq’s stock exchange, and excluding large private companies with high valuations and NYSE companies. Nonetheless, despite its tentative footprint, the SEC/Nasdaq rule has faced significant court challenges.
Proposed Legislation: ESG Simplification Act. The ESG Simplification Act, introduced in the US House of Representatives in February 2021, mandates a range of CSR/ESG disclosures related to climate-related risk, executive compensation, and diversity. This proposed legislation would standardize what many companies are already disclosing voluntarily. Its scope extends beyond board composition to a broader proportion of the workforce. However, diversity-related disclosures under the Act are quite limited; that is, “companies need only disclose whether they have adopted any policy, plan, or strategy to promote racial, ethnic, and gender diversity among board members and executive officers.” (P. 43.) Under the Act, the SEC would provide oversight and enforcement.
Author’s Proposal for Involuntary Comprehensive Disclosures
After showing the deficiencies of extant and proposed diversity disclosure regimes, the article proposes an aspirational disclosure regime that includes the following components:
- descriptive statistical disclosures of the self-identified race, gender, LGBTQ+, and disability status of board directors as well as all top executives and employees;
- forward-looking provisions that require companies to disclose: (i) internal diversity assessments, hiring of diversity managers, and their specific roles; (ii) policies and programs to increase employee diversity, such as recruitment, advancement, and retention programs; and (iii) steps taken to increase board diversity;
- significant sanctions for noncompliance;
- expanding the scope of application to all public companies and private companies with large valuations; and
- oversight and enforcement by a non-SEC regulator (e.g., EEOC, Dept. of Labor), given the SEC’s limited investor protection mandate.
Adediran acknowledges that these proposals are aspirational and “[w]ithout a major shift in politics, it is unlikely that Congress would mandate diversity disclosures.” (P. 48.)
The Paper’s Implications for Scholarly Debate and Future Research
Diversity Disclosure Blind Spots
Too many legal scholars and policymakers have focused on board diversity and neglected other levels of management and employees. The importance of this blind spot is buttressed by social science research concerning effective mechanisms for advancing diversity. Researchers, such as Frank Dobbin and Alexandra Kalev, illustrate the importance of focusing on middle management, rather than simply the board, in advancing diversity. Adopting this wider lens is pragmatic because employee movement through an organization, entry into middle management, and ultimate ascent to the C-Suite is the traditional path and progression toward becoming a director of a public company. Hence, a laser focus on corporate boards to the exclusion of other employees and specific firm practices that affect them may prove ineffective in achieving sustained diversity on a broader scale.
Disclosure Expectations Gap
Disclosure is often not enough. By nature, it is a moderate form of regulation, relying on market actors to influence corporate behavior. Despite receiving considerable pushback from some corporate observers, disclosure burdens, such as those in a comply-or-explain format, often pale in comparison to prescriptive regulation. Adediran’s claim that diversity disclosures are important to a wide range of stakeholders beyond shareholders is correct. However, relying on a range of fragmented stakeholders to advance diversity and other issues implies coordination, strategy, and leadership. Leon Sullivan’s creation of the Sullivan Principles, a voluntary code of ethics applied to corporate operations to remediate racial inequity, particularly labor practices in Apartheid South Africa, illustrates this dilemma. The Principles’ key features included: (i) periodic reporting; that is, disclosure; (ii) third-party auditing by a public accounting firm; and (iii) stakeholder engagement; that is, informing stakeholders of the company’s annual rating and allowing them to respond. Stakeholders equipped with mandatory or voluntary disclosures must then determine whether to take extreme action, such as investor exit, or an incremental approach more focused on maintaining voice under the threat of exerting economic clout.
Voluntary regimes are often critiqued as an accommodation to business interests because they lack enforcement beyond largely looking-glass and reputational effects, but they also recognize the potential for legislative failure, political gridlock, scope and scale challenges, as well as the need for business buy-in and filling regulatory gaps. Attainable voluntary codes or disclosure regimes sometimes foreshadow future legislation. However, legislatively mandated disclosures may provide permanence, uniformity, and additional incentives to comply, among other things. Professor Lisa Fairfax explains that voluntary and mandatory disclosures are not necessarily at odds, but rather “inextricably” linked to a dynamic process and part of an interconnected feedback loop.
Corporations and their leadership, whether passively or actively, have contributed to marginalization and exclusion for a significant part of US history. They are both part of the problem and the solution. As the legacy of Leon Sullivan illustrates, raising the economic ante for companies with disclosure and other mechanisms assists in broader systemic and firm-level changes.
Jan 26, 2023 Anna Gelpern
Corporate finance and public finance have a history of sharing market infrastructure, legal forms, and colorful terms (as when an infamous distressed debt trader used “United States’ security” to mean junk). The history of sharing invites reasoning by analogy, which often morphs into genealogy and positions 19th century London as the primordial soup for today’s market institutions. It is a sensible research strategy—London was and is a fruitful place—but formal similarities sometimes obscure critical context and alternative genealogies, leaving lawyers to ponder apparently meaningless clauses and pointless transactional techniques. Enter historians.
Marc Flandreau has a large body of solo and co-authored work about the London Stock Exchange, whose dominant market position and evolving governance practices over the course of the 19th century backstopped financial globalization, colonial expansion, and economic development. Two of Flandreau’s recent papers resonate in particularly intriguing ways with contemporary challenges. Both deal with the problem of inter-creditor equity and seemingly ineffectual contracts. This review will focus on the first, more developed paper. The second is mentioned briefly in closing—” target=”_blank” rel=”noopener noreferrer”>watch this space.
In The Puzzle of Sovereign Debt Collateral, Flandreau, Stefano Pietrosanti, and Carlotta Schuster revisit secured sovereign lending in the 19th and early 20th centuries. Formal hypothecations grew in popularity over time and were commonplace in sovereign debt as late as the 1920s, even as market participants and officials publicly acknowledged that creditors had no way of seizing revenues, or repossessing and monetizing physical assets. Secured sovereign debt went into hibernation with much of the sovereign bond market after the Great Depression, but has re-emerged recently with a wave of commodities-based lending in Africa, Asia, and Latin America.
Authoritative accounts of sovereign hypothecation to date have focused on enforcement—asset seizure—reasoning by analogy to corporate debt. They explain it either as “contracting for intervention” (ceding sovereignty to the proverbial gunboats) or as a lawyer-assisted mirage, unenforceable pablum fed to gullible Englishmen by unscrupulous borrowers in faraway lands.
Flandreau and co-authors highlight multiple problems with these accounts. Among these, the British government publicized and adhered to a policy against intervening on bondholders’ behalf save for carefully delineated exceptions (notably Egypt). Gunboat enforcement was rare, and did not target collateral as such. On the other hand, market participants and their fancy lawyers could not have been unaware of high-profile English court decisions blocking creditors’ attempts to grab collateral, even when it was stashed next door to the London courthouse. All the press and market chatter surrounding the court proceedings seems at odds with the “snookered bondholder” theory of sovereign hypothecation. Most curiously, 55 out of 67 contracts purporting to effect hypothecation between 1849 and 1875 had no terms at all for collateral seizure or sale; about a dozen specified such procedures, and did so in some detail. In other words, 19th century English lawyers knew how to write a conventional pledge, but chose not to.
The authors’ alternative hypothesis is that information production—not repossession and liquidation—was the main point of secured sovereign debt. Market participants harnessed the legal technology of secured credit to build robust information-forcing architecture in the age of absolute immunity, when lending to governments was “a blind date.” Contracts included elaborate language for continuous project and fiscal revenue reporting, and mobilized networks of public and private agents charged with monitoring the collateral. The press reported and the London Stock Exchange posted regular updates in prescribed form, accessible to bondholders as a group. Pricing data suggests that creditors valued seemingly unenforceable asset and revenue pledges. When the Economist exposed flagrant misreporting in a Honduras railway loan purportedly secured by physical assets, neither the government nor the stock exchange proposed to bolster creditors’ ability to seize collateral. Instead, the London Stock Exchange began requiring underwriters to attest to information accuracy.
Flandreau and colleagues describe an intricate web, in which “the information modules put together under [apparently unenforceable] hypothecations could be plugged into other institutions, creating positive externalities” for capital mobilization and economic development. Then and now, project finance, secured credit, fiscal monitoring, reputation-building, market gate-keeping, and contract discipline interact in multiple complex ways. Corporate precedent is relevant, but not for its emphasis on enforcement: “[T]o the extent that sovereign collateral mirrored the features of corporate finance, it was through the creation of information governance and liability.”
From today’s public finance perspective, this research calls for a more nuanced institutional examination of recent controversies surrounding Sri Lanka’s pledge of Humbantota Port assets to Chinese lenders, Chad’s oil-backed debt to Glencore, Finland’s insistence on collateralizing its lending to Greece, and official bilateral lenders’ use of offshore escrow accounts. Meanwhile, shedding light on the sovereign hypothecation puzzle might be useful in another way: prompting scholars to revisit the information function of collateral in corporate debt.
In closing, a heads up. A decade ago here, I reviewed a delightful article (part of a larger influential body of work) attempting to trace the origins of another seemingly ineffectual contract contraption, the pari passu (equal step) clause in sovereign debt. A new work in progress by Marc Flandreau reconsiders and brings new evidence to the perennial contest over the meaning and function of sovereign pari passu clauses. He rejects the dominant policy view of sovereign pari passu undertakings as (poor) safeguards against formal subordination, and argues that the much-maligned ratable distribution reading that got Argentina and others in trouble may be right after all.
The analysis again hinges on the role of the London Stock Exchange. Recall the dominant view that, with no sovereign bankruptcy court to stop new borrowing, block enforcement, define the estate and distribute it ratably among similarly situated creditors, the modern pari passu clause is at best unwieldy and likely ineffectual. Enter the stock exchange which, in Flandreau’s account, had a comprehensive view of the sovereign debtor’s finances, and counted all or nearly all its creditors among its members. The stock exchange could also shut defaulting debtors out of the market altogether. Under these conditions, the exchange could in fact effect ratable distribution of the debtor’s payments, and even make bondholders (its members) that get preferential payments from the debtor fork over their gains for pro rata sharing with the rest of the creditors. Note that such inter-creditor obligations might not even appear in the debt contract—but might be found in the rules or norms of the stock exchange. More broadly, Flandreau’s 2022 piece takes issue with the “contract paleontology” approach to interpretation that I found delightful in 2012, and offers an alternative institutional roadmap with causal links running in unconventional directions. Since neither pari passu nor public-corporate finance comparisons are going anywhere, watch for new versions.
Cite as: Anna Gelpern,
All Roads to the Stock Exchange, JOTWELL (Jan. 23, 2023) (reviewing Marc Flandreau, Stefano Pietrosanti, and Carlotta E. Schuster,
The Puzzle of Sovereign Debt Collateral: Big Data and the First Age of Financial Globalization,
CEPR Discussion Paper No. DP17286 (2022); Marc Flandreau,
Pari Passu Lost and Found: The Origins of Sovereign Bankruptcy 1798-1873,
INET Working Paper No. 186 (2022)), https://corp.jotwell.com/all-the-roads-to…e-stock-exchange/.
Nov 3, 2022 Charles O'Kelley
A key problem for corporate directors and a key concern of modern corporation law is the creation and maintenance of management systems designed to identify and optimally reduce the firm’s exposure to internal misconduct and foreseeable external risk. In recent years, that problem has come to include concern for the implications of climate change and globalization. Yet Society and its institutions, including corporations, were inadequately prepared for the Covid-19 pandemic. Why were we so unprepared, and what are the implications of the pandemic for corporation law going forward? To understand the implications of the pandemic, we must understand how it unfolded, what tools were in place to combat it, and how key actors responded to the crisis. While we each experienced the pandemic, and are still living in its shadow, a detailed overarching understanding of what happened would be missing but for a magnificent history of the present, Adam Tooze, Shutdown: How Covid Shook the World’s Economy (2021) (“Shutdown”). The history detailed in Shutdown, though not focused on corporation law as such, reads and can be understood as an extension of the crisis in corporation law theory that was unfolding as the pandemic struck.
For the last decade of the twentieth century and most of the current century, corporate law could be taught comfortably by reference to a near universally recognized governing doctrine. The end of history for corporate law was at hand. Rejecting Adolf Berle’s mid-twentieth-century understanding, corporations were now viewed not as social institutions, but as nexuses of private contracts united by one overriding purpose – the maximization of shareholder value. The role of the board of directors and subordinate officers was not to serve stakeholders or society, other than indirectly, but to pursue shareholders’ wealth-maximization interests. Correspondingly, state corporation law, including common law fiduciary duties, as well as federal securities laws, could best be understood as guardrails designed and implemented to ensure that neither directors nor officers misused their power to pursue ends unrelated to, or counter to, shareholder value maximization. While there was room in this formulation to talk about corporate social responsibility or the importance of stakeholders, such conversations were generally understood to be tangential to a proper understanding of corporation law.
This comfortable understanding of corporation law began to unravel with the cultural and political shock delivered by the election of Donald Trump. As the anticipated election of Hillary Clinton neared, few responsible policy-makers doubted that the earth was in the second stage of what economic historians call “the Great Acceleration” – the period beginning around 1950 when the earth began to warm and its climate change at a pace previously unseen in recorded history, Nor did most responsible policy makers doubt that it was mankind’s actions that were responsible for the Great Acceleration and that cooperative and dramatic international actions would be required to prevent calamitous future consequence. This global consensus was thrown into disarray when Trump as one of his first official presidential acts withdrew the United States from the Paris Climate Accords. Many more shocks to our understanding of America and its place and role in the world were to follow and much of Trump’s presidency served both to divide Americans on major issues and to turbo-charge activists on both sides.
As Trump’s presidency neared the end of its term, Democratic candidates began to campaign in earnest for the privilege of running against him. Central to the platforms of Elizabeth Warren and Bernie Sanders was the assertion that America’s problems could be traced not only to Donald Trump but to corporations and their rapacious pursuit of shareholder wealth. Both promised to reign in those corporations by imposing higher taxes, and even, by requiring corporations to obtain a federal charter that would require corporations to promote the interests of stakeholders and society at the expense of shareholder wealth maximization. In 2019, in the midst of this strident criticism, the Business Roundtable issued a new statement of corporate purpose signed by the vast majority of its CEO members embracing the view that corporations should be run “for the benefit of all stakeholders—customers, employees, suppliers, communities and shareholders.”
This shocking change in corporate leaders’ articulation of corporate purpose was soon followed by other events that challenged long-accepted views about the nature of the corporation and the boundaries between corporation law and other law school subjects. For example, the epic collapse of the stock market in March 2020 and its equally epic reflation in value in the following year as a result of massive intervention by the Federal Reserve seemed inconsistent with the notion that corporations are private entities subject to the risks of the market; why should we bail out shareholders when they suffer losses, when we also reward them with favorable capital gains treatment when times are good? Likewise, the New York Times 1619 project and the Black Lives Matter movement cried out for an understanding of the corporation’s historical and current responsibility for racial inequities. Then, of course, came the Covid pandemic which has thrown our understanding of both ordinary life, work, the purpose of the corporation, and the role and nature of government into disarray. Then 2022 brought the Russia-Ukraine conflict and the stunning collapse of energy and food supply lines, forcing us to think even more urgently about globalization, the political competition between great and lesser nation states, and the role of corporations as instruments of national policy.
Given these events, how are we as teachers of corporation law now to bring coherence to our subject? How are we to grapple with a rapidly changing understanding of the larger society in which the modern corporation operates? As a lifeline and foundation for moving forward, I highly recommend Shutdown.
Like most of us, eminent economic historian Adam Tooze did not realize the significance of the already raging pandemic until early March 2020. Like most of us, the pandemic cast his life into disarray, forcing changes in travel plans and research projects. Early on he realized that chronicling the pandemic as it unfolded demanded his full and immediate attention. The result of his changed life and research agenda is Shutdown, which traces the Covid-19 crisis from its inception until Biden’s inauguration in early 2021. Shutdown is a history of the present, giving us a lens on events we all lived through, and showing us the underlying themes and connections between global actors and events that were not obvious or even knowable as events transpired. Importantly it has much to help in our understanding of how leaders, including corporate boards of directors should act in the face of existential risks and uncertainty
Central to how many of us teach Corporations is the centrality of risk and uncertainty. Entrepreneurs, firms, and boards of directors exist as devices to deal with uncertainty, and to ensure that economic decisions are made with due regard to the risks entailed. Equitable doctrines like piercing the corporate veil and directors’ Caremark monitoring duties minimize the extent to which firms may seek rewards by wrongfully shifting risks of loss to non-shareholders. And, central to Shutdown is a vivid account of how politicians, scientists, pharmaceutical ventures, central banks, corporations, and ordinary global citizens, coped with the onset and evolution of the Covid-19 crisis.
While Shutdown is a history of the present, Tooze situates 2022 against the backdrop of the revolution against democracy that began in the early 1970s, which revolution is still identified most closely with Reagan and Thatcher. That revolution introduced fiat money and the independence of central banks, crushed labor as a political force, deregulated many public services, and protected and promoted the interests of capital to a degree not seen since before the New Deal, feeding a corresponding rise in inequality. That fifty-year period coincided with the second wave of the Great Acceleration, also known as the Anthropocene, in which the impact of man on the planet has produced an increasingly fragile environment, notable not only for increasing risks from climate events, but also increasing risks from infectious diseases. Despite doubters, these risks are and were generally understood. However, they also are and were not treated with the priority that the risks rationally demand. In other words, the Covid-19 pandemic was not an unforeseen risk. We simply chose not to prepare for it. As Tooze describes, “as 2020 began, the disproportion between pandemic risk and the investment in global health was nothing short of grotesque.” On the American home front, “the U.S. health system was ramshackle and its domestic social safety net left tens of million at risk of poverty.”
The lack of preparation for the pandemic was accompanied by a deterioration in the relationship between citizens, on one hand, and governing elites on the other, and a similar deterioration in relationships between key nation states. Fueled in no small part, if not in major part, by the Reagan-Thatcher revolution, social trust in national governments had declined sharply, exemplified by Brexit and the Trump presidency. Likewise, fueled by the inconstancy of U.S leadership, including its withdrawal from the Paris Climate Accords, and its trade war with China, trust between nations states had eroded.
In hindsight, we now know that Covid-19 was not particularly lethal as measured against historic plagues. But the lack of preparation and lack of social cohesion between citizens, governments, and nation states, quickly turned a potentially simple crisis into a global polycrisis, the unfolding of which Shutdown grippingly chronicles. When the health systems in first Italy and then New York City were overwhelmed by the first wave of Covid-19, citizens and authorities panicked together. The result was the sudden and complete shutdown of public life, much of commerce and business activity. This global disruption of normal life was unprecedented and led to a threat to the stability of the world economic system that dwarfed the risk of the 2008 crisis, and led to the printing of fiat money by both central banks and legislatures on an unprecedented scale. World capital markets crashed, then rebounded in a dizzying turnaround.
In the United States the unfolding polycrisis played out against the backdrop of the 2020 presidential campaign. As the first wave peaked, the polycrisis morphed again with the murder of George Floyd. Spontaneous demonstrations and street marches for social justice sprang up worldwide fueling anger in more conservative circles who saw a double standard at work with social distancing rules.
Biden’s narrow victory was immediately followed by the announcement and roll out of a series of vaccines. However, the second wave of the Covid-19 pandemic was accompanied by the threatened end of generous unemployment and other benefits, including the CDC eviction ban. In December the rump Congress provided an additional package of financial assistance for the most at risk.
As the second Covid-19 wave raged, the polycrisis received new fuel as well. On January 6, 2021, Trump supporters invaded the nation’s capital, reacting to Trump’s insistence that the election had been stolen. Despite this crisis, Biden took office peacefully, promising to work to retore America’s infrastructure, to build on the successful innovations in social policy that had allowed America to survive the dislocations of the pandemic, to make major investments in the Green New deal, and to finally make good on the promise of an anti-racist society. In short, 2021 began with the hope that America at least had learned its lesson. The Anthropocene is upon us, and we must prepare for it.
Tooze concludes Shutdown, with two observations. First, the lesson that the Biden administration and global central banks learned is that money can be printed liberally without risk of inflation. Instead of being a tool to be used with restraint, money printing now becomes a means for nation states to aggressively tackle major social problems, including climate change. Accordingly, the Biden administration plan as understood at the beginning of 2021 was to “deliberately run the economy hot.”
Second, Tooze identifies China and its authoritarian governance system as the key geopolitical risk for the United States and the extant world system. Russia receives only passing mention in Shutdown, and never as a serious threat to the world system’s stability.
The world Tooze saw in the early days of 2021, is not the world we are now experiencing. It turns out that printing money does have serious inflationary consequences. It turns out that Russia could trigger a perhaps existential crises for the world system. That the world can change so quickly, and in ways not foreseen by thoughtful expert observers, is a lesson for leaders, including corporate boards of directors, charged with identifying and preparing for potentially catastrophic risks.
As the Covid-19 polycrisis exemplified on a global level, we have many examples of polycrises in corporation law, beginning most famously with the Caremark case and continuing recently with the debacle at Boeing. As with the Covid-19 crisis, most of those famous corporate cases involved not a failure to foresee a particular risk, but a failure to take appropriate action, coupled with subsequent decisions or inactions that turn a simple crisis into a polycrisis.
As Tooze summarizes:
Crisis-fighting is both relentless and hectic. It is driven by the urgency of the immediate situation. It is caught in a tangled web of interests and must make up its instruments as it goes along. It is also, however, guided by reflection on past crisis-fighting. Whether in the form of books, articles, or “folk narratives,” contemporary history is part of that process of collective learning.
What Shutdown offers us as teachers of corporate law, is, of course, a compelling account of crisis management done right and gone wrong in a myriad of overlapping settings. But, it also provides an opportunity to reflect on both the societal purpose of the corporation, the board of directors’ risk management function, and how stakeholder governance might enhance the corporation’s sustainability in an increasingly fragile social and physical environment.
Oct 5, 2022 Bill Bratton
Mark Roe,
Corporate Purpose and Corporate Competition,
Euro. Corp. Governance Inst. (forthcoming 2023), available at
SSRN.
There has been a subtle shift in the standard academic account of shareholder primacy. The touchstone citation for shareholder primacy used to be Jensen and Meckling’s famous 1976 paper on the theory of the firm. This has been displaced by Milton Friedman’s equally famous takedown of corporate social responsibility in 1970 on the pages of the Sunday New York Times. The shift in the citation pattern follows a shift in the leading discussion points. Where people once worried that agency costs were burning up billions of dollars of shareholder value, now, with agency cost containment and the emergence of ESG investing along with movement towards social welfare enhancement as corporate purpose, shareholders sacrifice their own returns for the greater good (or at least make gestures in that direction). A formidable task results for academic corporate law. It needs to reconstruct its own paradigm to explain and justify this turn to social responsibility. Friedman as a result emerges as the fundamental theory-giver rather than as a “but cf.” cite in a footnote describing corporate social responsibility as a related but irrelevant policy discussion.
Friedman’s New York Times essay expanded on a handful of pages in his book on political economy, Capitalism and Freedom, first published in 1962. We there come across a structural observation heretofore missing in discussions about ESG, corporate purpose, and the voting habits of institutional shareholders. Friedman turned to CSR in a chapter on monopoly, observing that the manager of a corporate entity operating as a pure competitor had no room to worry about CSR. The managers of a producer possessing monopoly power, in contrast, had rents to dispose of and allocative choices to make. CSR concerns are thereby conceptually tied to and perhaps limited by market power.
It is a powerful point. Kudos to Mark Roe for bringing it to bear on today’s governance discussion in his forthcoming article, Corporate Purpose and Corporate Competition.
Roe sets up a big policy table, describing today’s governance climate as a “purpose pressure” zone. He then puts Friedman’s point on the table, suggesting that the pressure will register more intensely as market competition becomes less intense. It follows that the present governance dispensation is not only a function of demand for a socially responsive purpose, there is also a supply side–the subject company must have the financial ability to respond and not all are so positioned. This gets us to the big question: whether there have there been changes in the industrial organization landscape to which we might look to account for the recent intensification of purpose pressure. “Well, maybe” is the answer. Roe surveys recent commentary on industrial organization to identify three “rent-increasing channels,” some of which fall on the bad side of competition policy with others following as the outcomes of intense competitive struggle. They are: (1) a decline in the intensity of competition, (2) an increase in salience of winner-take-all contests due to increasing scale economies and the proliferation of networked means of production, and (3) an increase in institutional shareholding concentration. Roe steps out of the industrial organization frame to add a fourth—the decrease in labor’s power to extract a share of corporate rents. And there’s a major caveat—not all in the field subscribe to the picture of competitive decline.
Roe describes numerous implications, some destabilizing for shareholder primacy and others complicating the ESG picture. I’ll mention only a few here. Shareholder primacy does its productive best, says Roe, in highly competitive industries and its justificatory base weakens as competition loses intensity. Meanwhile, a firm with a sterling ESG profile could be jockeying politically to protect its rent base. There also may be a direct relationship between the rent sacrifice bound up in ESG initiatives and management slack, at least to the extent that managers hew tightly to shareholder interests only in highly competitive situations and governance institutions prove unequal to the task of eliminating slack where competition is disabled. Social agendas could trigger instability inside of corporations given an outside polity lacking the stable political consensuses that might provide decisive answers to social questions.
I should note that all of this comes in the absence of a political agenda. The author is just trying to get a handle on what is going on. It nonetheless also bears noting that the description cuts against the grain of today’s academic mainstream, which pursues strategies to integrate purpose pressure into the received model of shareholder primacy. The idea is to leave the Friedmanian public private divide intact (and to continue to hew to methodological individualism) while admitting a public coloration into the corporate governance picture. I am intrigued by much of this work but skeptical about the bottom line. So far as I can tell, the rabbit has not yet been pulled out of the hat. I am accordingly receptive to Roe’s intervention, which sounds a much needed note of caution. It makes its points scrupulously as it does so. This is an exploratory paper, blissfully free of the essentialist claiming that so often hobbles otherwise good work in the field.
Finally, this is a rare cross-disciplinary exercise connecting corporate and antitrust law. For us insular corporate types, it offers a steep ride up the learning curve and is all the more welcome for so doing.
Sep 5, 2022 Tom C.W. Lin
Ofer Eldar & Gabriel Rauterberg,
Is Corporate Law Nonpartisan?, __
Wis. L. Rev. __ (forthcoming 2023), available at
SSRN.
America is beset with partisan politics. The brinkmanship, dysfunction, and policies that emanate from political partisanship touch so much of American life, law, and society. Increasingly and prominently, businesses have been drawn into partisan debates on issues like gender equality, gun violence, reproductive rights, racial justice, and climate change. Many executives, investors, employees, activists, and other stakeholders now expect American businesses to play an active role in addressing many of society’s toughest challenges in the face of political institutions that too often seem too partisan to meaningfully confront those challenges. In response to a new wave of corporate social activism, national and local political leaders have both admonished and applauded businesses for their attempts to address social issues.
This new wave of corporate social activism has prompted many important questions and reexaminations of core issues at the critical intersection of business, law, and politics. One such foundational question is political partisanship’s impact on corporate law.
In a forthcoming article, Is Corporate Law Nonpartisan?, Professors Ofer Eldar and Gabriel Rauterberg offer an in-depth, fair minded examination of partisanship’s effects on corporate law and corporate lawmaking. Through a thoughtful study, that carefully weaves quantitative and qualitive analyses, the article offers a persuasive explanation of how partisanship may have contributed to key differences in state corporate laws and how safeguards against partisanship have contributed to Delaware’s sustained dominance in the competition for corporate charters.
First, the article quantitatively explores potential links between partisanship and corporate law making. Professors Eldar and Rauterberg carefully curated and created data sets that allowed them to examine how political partisanship could impact state corporate law, particularly with regards to “anti-takeover statutes, anti-litigation laws and hybrid legal forms that have a blended profit-social mission.” (P. 11.) Their findings suggest that partisanship has a meaningful impact on corporate law making. Specifically, they observed that “Democratic control is associated with anti-takeover legislation, particularly constituency statutes that permit managers to consider the interests of a broader set of stakeholders. This is also consistent with the finding that Democrats tend to pass laws that facilitate the adoption of hybrid forms.” (P. 18.) Additionally, they observed that anti-litigation statutes are not associated with Republican leadership in state government, “but there is some evidence that a subset of them, specifically loyalty waivers and universal demand laws are more likely under Republican rather than Democratic control.” (Id.) These empirical findings and observations offer a persuasive explanation of how partisanship contributes to critical differences in corporate laws among the states.
Second, the article uses corporate governance theory and legal history to qualitatively explain how Delaware’s insistence on non-partisan corporate law making maybe be an underappreciated factor in its dominance in the competition for corporate charters, particularly among large businesses. The article argues that part of Delaware’s appeal for corporate leaders resides in the unusually nonpartisan structural safeguards the state designed to shield its corporate law from partisan waves and whims:
The process by which Delaware makes corporate law is explicitly designed to be insulated from political partisanship, and it has been since Delaware became the principal home to incorporations a century ago. Delaware’s Constitution requires that the Delaware judiciary be balanced between Democratic and Republican judges and that changes to its corporate law receive supermajority support. The main source of legislative drafting for any changes to Delaware’s corporate law is not a political branch, but the Council of the Delaware State Bar Association’s Corporation Law Section. The major arms of Delaware corporate lawmaking—the legislative process and the courts—have both been carefully immunized from the normal political fray. (P. 5.)
The article contends that while all laws are political to some extent, Delaware’s intentionally nonpartisan approach is particularly attractive to large businesses because it offers their executives a stable and predictable, yet flexible set of rules to help govern their corporate affairs for the benefit of diverse bodies of shareholders with a variety of partisan political views. During a time, like the present, when partisanship has disrupted so many aspects of American law, society, and business, Delaware’s deliberately nonpartisan foundation to corporate law may be particularly appealing and reassuring to business executives seeking an enduring, steadfast ground to grow their enterprises.
In the end, the dysfunctional, hyper-partisanship that has plagued our political and democratic institutions in recent years appears to have no end in the near term. More and more businesses have been called upon by various stakeholders to step into the political voids and chasms caused by this unhealthy strain of partisan politics to help tackle some of the toughest issues facing society. As policymakers and scholars continue to debate and deliberate about the appropriate role of business in politics and society during this era of partisan angst, they will invariably be thinking of new ways to understand the dynamics between politics, business, and law. For anyone studying these consequential, unfolding dynamics, Professors Ofer Eldar and Gabriel Rauterberg’s recent article lights new, informed paths for further inquiry and action.
Jul 25, 2022 Da Lin
Corporate governance debates tend to dismiss “Main Street” individual investors as irrelevant. The traditional archetype of the corporation presumes that individual shareholders are apathetic because they own small stakes and confront collective action challenges. In the modern corporate landscape, individual shareholders are overshadowed by their institutional counterparts, who hold near-majority stakes in most public companies. Stories about individual investors tend to highlight their idiosyncratic goals or their distracting irrationality. Think of Charles Pillsbury, who bought a single share of Honeywell in order to campaign to end Honeywell’s munitions production for the Vietnam War. Or the recent meme stock craze, which was widely reported to be driven by “amateur” investors trading on social media hype instead of corporate fundamentals.
But there are important exceptions to this generalization, as Kobi Kastiel and Yaron Nili remind us in their article, The Giant Shadow of Corporate Gadflies. The article brings to the fore the underappreciated role that “corporate gadflies” play in promoting good corporate governance (at least from a shareholder-centric perspective). Kastiel and Nili describe gadflies as “small, ‘pesky’ individual shareholders who are engaged in the submission of massive numbers of shareholder proposals.” There are just a handful of gadflies in existence today, including William and Kenneth Steiner, John Chevedden, the Rossi family, and the husband-and-wife team of James Ritchie and Myra Young.
According to Kastiel and Nili, corporate gadflies function as “governance facilitators”: Gadflies prepare and submit mainstream governance reform proposals—those that proxy advisers and the largest institutional investors have already publicly endorsed—for inclusion on companies’ ballots. As the Article carefully documents, the influence of gadflies has grown steadily over the past fifteen years. Between 2005 and 2018, they accounted for 27.3% of shareholder proposals submitted to S&P 1500 companies, surpassing established institutional actors such as labor unions (21.9%) and public pension funds (15.3%). In fact, just five individuals accounted for 41% of all non-withdrawn shareholder proposals submitted to S&P 1500 companies in 2018.
Governance-related proposals submitted by gadflies have translated into meaningful changes at recipient companies. About a quarter of the proposals submitted by gadflies received a majority of the shareholder vote, which gives gadflies a higher success rate at the ballot box than most of their institutional counterparts. As others have observed, large institutional investors are “rationally reticent.” They publish detailed guidance on the “good” governance practices that they will vote to support. But for a variety of reasons, such as conflicts of interest and fear of attracting regulation, most large asset managers have no appetite for initiating reforms to implement those practices at their portfolio companies. Gadflies have stepped up to bridge this gap.
In fact, gadflies may function within an even broader collaborative ecosystem, in which they, institutional investors, and activist investors play complementary roles to hold corporate managers accountable to shareholders. In this framework, activist investors are the monitors: as Ronald Gilson and Jeffrey Gordon described in earlier work, activists “specialize in monitoring portfolio company strategy and formulating alternatives when appropriate.” The effectiveness of activist investors depends on their ability to credibly threaten to remove the board of directors in a proxy contest, which in turn partly depends on the arsenal of governance tools (such as majority voting, declassified boards, or shareholders’ right to call a special meeting) available to them at the target companies. Gadflies facilitate investor activism by enlarging this toolkit. Kastiel and Nili’s data show that gadflies have submitted more proposals relating to shareholder rights and the removal of proxy battle defenses than any other topic. And institutional investors are in charge of voting: They react to activists’ and gadflies’ interventions that reach the corporate ballot box and decide between competing positions.
Understanding gadflies’ function is particularly relevant today because, as Kastiel and Nili explain with some urgency, gadflies face possible extinction. In September 2020, the Securities and Exchange Commission amended the eligibility requirements for submitting shareholder proposals. This rule change means that the costs corporate gadflies must incur to finance their activities are now higher—perhaps prohibitively so. But rather than simply bemoaning this development, Kastiel and Nili see opportunities as well. There are opportunities for evolution; among other suggestions, they propose the creation of “Gadflies 2.0,” whereby the gadflies’ role could be assumed by a centralized “professional” organization that can handle the submission of shareholder proposals on a larger scale. More importantly, there are opportunities to advance the debate on the role that institutional shareholders should play in corporate governance. For instance, do the conventional arguments that justify large asset managers’ historical reticence to use their power, such as lack of capacity or specialization, translate easily to a purely administrative task like submitting shareholder proposals on reforms that asset managers have already endorsed? And is the current system, in which large institutional investors and proxy advisers determine market-wide governance standards akin to regulation, even structurally desirable?
Kastiel and Nili’s contribution is a valuable complement to the growing body of corporate law scholarship trained on institutional actors. It not only brings attention to the handful of individuals whose outsized influence on U.S. corporate governance has thus far been overlooked, but uses this case study to deftly illuminate the complex and evolving complementarity between different investor types.
Jun 22, 2022 Robert Rosen
Wisdom sometimes is best recognized by a traveler. In Delaware’s Fiduciary Imagination: Going-Privates and Lord Eldon’s Reprise, Professor David Kershaw of the London School of Economics revisits cases that we know very well, putting them in the context of British decisions, and elicits a distinction that appears obvious, yet comes as a bit of a surprise: There is a distinction between abuse of power and abuse of influence. These are two ideal types of the “source of obligation” for fiduciaries
Abuse of power flows from the grant of power to the fiduciary. Abuse of influence flows from the limited consent of the beneficiary. For example, controlling shareholders were once understood as being able to abuse their corporate powers. Today, it is more common to focus on how they can “threaten the minority to say ‘yes.’” Duties to creditors follow from influence over them near the debtor’s insolvency but do not flow from an abuse of corporate powers.
Abuse of power emerges from the fact that fiduciaries have power that stems from their undertaking. They “are clothed with power.” (quoting Hoffman Steam Coal Co. v. Cumberland Coal & Iron Co., 16 Md. 456, 464 (1860)). What are the duties of being “entrusted” with power? A narrow answer is prohibition on various forms of self-dealing by trustees. A broader answer is to take as granted that fiduciaries have power and analyze “good faith” in the exercise of it.
Over the last half-century, according to Kershaw, a different source of obligation has emerged in courts: the “influence conception.” In this conception, the fiduciary relationship is that of principal and agent. It has a transactional base and the scope of the powers transferred is narrow. The fiduciary, moreover, has discretion to exercise a power only if its transfer is “truly voluntary.” It follows that any influence over the principal exercised by the fiduciary is suspect. Inquiries into whether there has been influence can become expansive, “subtle,” as is illustrated in decisions regarding special litigation committees and going private tender offers. The influence conception also allows for the expansion of the class of traditional doctrinal fiduciaries to include others who have influence, including parties to “confidential relations.” Furthermore, as the source of obligation has relational origins, individuals can be fiduciaries in some particularized matters, but not in related ones.
The influence conception of fiduciary obligations “has no limit” because “[e]verywhere … there are situations in which one person is in a position to detrimentally affect another.” Although judges limit it for pragmatic reasons, “the possibilities generated by the fiduciary influence conception will continue to serve the plaintiff bar … in generating a plethora of legal claims.” As we know, duties of loyalty and what constitutes informed consent can expand both extensively and intensively.
These two sources of obligation overlap. Kershaw documents cases in which the decision moves between the abuse of power and abuse of influence conceptions without comment. They can justify similar results. Despite accepting that fiduciaries have powers, particular exercises may be rejected because the fiduciary exercised “undue influence.” Determinations of undue influence can derive from both sources. Furthermore, the differences between them are minimized by understanding that the fiduciary has a very narrow remit. And good faith can be analyzed simply as a duty of loyalty.
A gap between the abuse of power on one side and undue influence on the other is the justified power of a fiduciary.
The two accounts are grounded in contrasting models of the fiduciary relationship. In the influence conception, serving a principal is to be servile. Fiduciaries only exercise justified power when they eschew being influential. The fiduciary of good character is a good listener. Fiduciaries in corporate law usually poorly fit this conception, as in fact they exercise rather unregulated corporate powers. Kershaw nicely depicts how this tension is a driver of today’s corporate law.
The abuse of power conception, on the other hand, is appropriate for powerful actors, the usual subjects of corporate law. Working as a fiduciary allows one powers that can be abused. The fiduciary of good character knows that their undertaking is not merely relational and has been shaped by both public and private forces. By this broad and open-ended remit, fiduciaries have been entrusted with moral, including political, authority. Louis D. Brandeis, for example, whose opinion in Southern Pacific Co. v. Bogert, 250 U.S. 483, 487-88, 491-92 (1919), states the abuse of power conception for corporate actors, practiced law as a powerful fiduciary, serving not client interests, but working as “counsel to the situation.”
Justifying fiduciaries’ exercises of power can depend on sympathetic understandings of their character, servile or moral as the case may be. Having public obligations, fiduciaries are neither free to totally disregard moral and political needs. But nor are they servants of the state. Human needs and democratically-determined goals compete with corporate loyalties. Fiduciaries make moral decisions by which they reveal themselves.
In thus reminding us of the source and nature of the power vested in corporate fiduciaries, Kershaw brings the character of the particular fiduciary back to the center of the description of corporate fiduciary relationships. The choice of which individuals become fiduciaries matters. Diversity, or the lack of it, may be highly consequential. Operating beyond beneficiaries’ consent, corporate fiduciaries’ characters influence their decisions and can become a subject of inquiry in contested actions.
This focus on character seems very old-fashioned. It is associated with a society that accepted inequality and unequal access to power. On the other hand, urgent needs may demand unconsented to exercises of power. ESG decisions, for example, may be better analyzed by inquiry into the morality of the fiduciary than into principal’s consent.
As in any excellent article, Professor Kershaw raises more questions than he can answer. He sets an agenda for inquiry into the modern relevance of the abuse of power conception of fiduciary obligations.
