I.
Theory of Financial Institution Failure

In recent years, it has become apparent that the failure of large, interconnected nonbank financial institutions, such as hedge funds and investment banks, can create substantial systemic risk and thereby impose external costs on the financial markets and economy.² Because no financial institution has the incentive to limit its own systemic risk,³ and because collective action by market participants to prevent systemic risk is unlikely,⁴ some regulation is needed to minimize the external costs produced by the failure of “too big to fail” (TBTF) institutions. Any remedial regulation should (1) prevent overly risky behavior by a TBTF institution that could cause it to fail and create contagion,⁵ and (2) prevent the panic among investors that can precipitate an institutional failure.

Regulation to avert systemic risk, however, can also create moral hazard and uncertainty. One way of reducing systemic risk is by “bailing out” TBTF institutions—guaranteeing their agreements with creditors and counterparties—which reduces the chances of their failure by preventing runs on the institutions. The problem with this approach, however, is that while loss-fearing counterparties and creditors normally exert market discipline to prevent institutions from taking on excessive risk, parties that come to expect future bailouts reduce their discipline accordingly. A policy of “constructive ambiguity”—only bailing out some creditors and counterparties so that none can count on a bailout ex ante—reduces this moral hazard. But constructive ambiguity also creates uncertainty in financial markets, leading panicked investors to withdraw their funds en masse from other financial institutions, which can increase systemic risk. The benefits of constructive ambiguity in reducing moral hazard will be produced most effectively through a discretionary and transparent process that retains uncertainty over the outcome of regulatory decision-making with regard to bailouts, but involves less ambiguity over the rules and process informing such decision-making. Creating clear procedures but preserving uncertainty over the outcome of a regulatory decision produces a better balance between uncertainty and moral hazard: Clear procedures will calm panicky investors, while uncertain outcomes will curb moral hazard.

II.
Evaluating Our Current Regulatory System

Our current regulatory system is suboptimal in both its ex ante and ex post regulation of systemic risk. Ex ante, the system fails to reduce the external costs caused by the overly risky behavior of nonbank financial institutions. Prudential regulations to curb such behavior are either insufficient, as with the Securities and Exchange Commission’s regulation of investment banks through the Consolidated Supervised Entities program, or nonexistent with respect to certain financial institutions, such as hedge funds. Ex post, the system does not sufficiently reduce the systemic risk caused by the failure of nonbank financial institutions and does an inadequate job of limiting the moral hazard and uncertainty that regulation creates. Under our current regulatory framework, when a large nonbank financial institution is on the verge of failure, regulators have two options: either undertake last minute, ad hoc actions to rescue the institution or permit the institution to file for bankruptcy. The problem is that this ad hoc approach can result in (1) bankruptcy filings by TBTF institutions that will likely cause contagion, as exemplified by the failure of Lehman Brothers, and (2) uncertainty in regulators’ decision-making processes that can create panic and worsen an ongoing financial crisis, also apparent during the aftermath of Lehman Brothers’ bankruptcy filing.

III.
The Obama Administration’s Framework for Regulatory Reform

The Obama administration’s proposed legislation would establish rules by which the Federal Reserve would designate certain financial institutions as TBTF—or Tier 1 financial holding companies (Tier 1 FHCs)—which would become subject to more stringent ex ante prudential regulations. The determination of whether an institution should be deemed a Tier 1 FHC would not depend upon the legal status of the institution, such as whether it is legally a bank, a hedge fund, or an investment bank, but rather on the extent to which a failure would be likely to impose external costs on financial markets and the economy. The Obama administration’s proposal retains the current bankruptcy process but adds a resolution regime that governs the failure of Tier 1 FHCs in some circumstances in order “to efficiently and equitably resolve the claims of creditors and other stakeholders”⁶ through a legal process similar to bankruptcy. Although the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) must approve a decision to invoke the resolution regime by a two-thirds vote, the Treasury would ultimately decide whether to invoke the regime upon consultation with the President.

The Obama administration’s proposal improves upon our current regulatory system, but it could do more to avert the systemic risk that could result from the failure of a Tier 1 FHC. Although the proposed framework instructs the regulatory agencies to consider “serious adverse effects” on the financial system and economy when deciding whether to invoke the resolution authority, the procedures for reaching such a determination are so stringent—requiring near consensus among numerous regulatory agencies—that it seems likely that at least some financial institutions whose failure will cause systemic risk will not be bailed out. The proposed legislation also leaves open the possibility that regulators, at the eleventh hour, might elevate moral hazard concerns above concerns about systemic risk. Furthermore, giving the Treasury—an agency firmly within the Executive branch—the ultimate authority to invoke the resolution regime overly politicizes what should be a technical decision based on an assessment of the expected systemic cost.

I also contend that the proposal fails to sufficiently reduce uncertainty in policymaking decisions, which could trigger panic and contribute to an environment where short-term creditors are likely to run a Tier 1 FHC. First, because the proposal leaves open the possibility of bankruptcy, creditors and counterparties of the institution now must worry about their ability to recover if the institution fails under both bankruptcy law and resolution rules. Second, the legislation does not require regulators to disclose the basis for the decision of whether an institution’s failure creates “serious adverse effects.” Without transparency in this crucial determination, ambiguity over the decision-making process remains, creating additional uncertainty for investors.

IV.
An Alternative Regulatory Reform Framework

While the Obama administration’s proposal has clear benefits, I suggest modifying the proposal’s ex post process for resolving the failure of TBTF financial institutions in order to prevent systemic risk more effectively and to reduce uncertainty. I propose that the Federal Reserve be given unilateral power to authorize the FDIC to seize a failing institution and place a value on the expected cost to the financial system and the economy of the institution’s failure. A cost-benefit provision in the new statute would then require the FDIC to provide the institution with financing only up to the cost of the systemic risk created by that institution’s failure.⁷ This will ensure that the expected cost of any bailout is less than the expected cost of systemic effects. Under my proposal, institutions deemed to be Tier 1 FHCs would not be subject to the bankruptcy process.

This alternative regulatory framework will improve upon the administration’s proposal in three ways. First, it will prevent systemic risk more reliably without worsening moral hazard. The cost-benefit provision of the resolution process ensures that systemic risk is properly considered and prioritized ex post in resolving a Tier 1 FHC failure. Under my proposal, regulators would not be permitted to elevate concern about creating moral hazard above the problem of systemic risk when deciding whether to allow a failed institution to liquidate. Furthermore, even though it is more likely under my proposal than under the administration’s proposal that Tier 1 FHCs will be rescued to some extent, any moral hazard will be limited because only short-term creditors with high-priority claims against an institution, not long-term subordinated creditors, are likely to recover fully in a resolution process.

Second, the Federal Reserve, as a regulatory agency with substantial prior experience regulating large, complex financial institutions and as the agency that would be responsible for monitoring and regulating Tier 1 FHCs ex ante, would have the most expertise and independence to make sound technical determinations about whether the systemic risk exception should be invoked.

Third, this framework reduces the additional harm and contagion caused by uncertainty in regulatory behavior without losing the benefit of reduced moral hazard. By removing the possibility of bankruptcy, the framework I propose eliminates a layer of legal uncertainty that could contribute to panic and trigger a run on financial institutions. Requiring transparency in the Federal Reserve’s methodology for making a systemic risk determination also reduces the ambiguity in decision-making procedures that can exacerbate a financial crisis.

Acknowledgments:

Copyright © 2010 New York University Law Review.

Alison M. Hashmall is a J.D. Candidate at New York University School of Law.

This Editorial introduces and is an abbreviated version of Alison M. Hashmall, Note, After the Fall: A New Framework To Regulate “Too Big to Fail” Nonbank Financial Institutions, 85 N.Y.U. L. Rev. (forthcoming June 2010).

Now that we know that ongoing, day-to-day franchise tax competition is just not happening, we need to reframe the inquiry to examine the constraints that Delaware does face. If no state is immediately poised to take franchise revenues away from Delaware, does Delaware have unlimited discretion? If it does not, where do those limits come from?

Delaware does face constraints, and they do not seem small. First, Delaware’s chartering business interacts with the dynamism of the real economy in ways that make it hard for Delaware to rest on its franchise tax laurels. Even if no other state actively competes for chartering revenue, Delaware itself must vie to sell new charters because it needs to draw reincorporations from other states. Conceptually, this is clear. The question is its degree. When, decades ago, business turnover in the economy was slower than it is today, this competitive channel was not particularly important. Firms, or most of them, stayed organized from year-to-year about the way they had been. Once Delaware captured a firm’s franchise revenue in one year, that firm tended to be a reliable Delaware taxpayer in future years. But as corporate restructurings, spin-offs, mergers, and turnover have accelerated, keeping this channel flowing in to Delaware has become increasingly important for the state. Indeed, that acceleration has squeezed the half-life of its tax base down from a quarter century to a decade. That is, half of Delaware’s tax base in recent years comes from firms that got their Delaware charter in the prior decade; twenty years ago the tax base was more stable, with half of it coming from firms that got their Delaware charters in the prior quarter of a century. Delaware must run ever faster just to stay in place.

Second, another state, North Dakota, actively entered the market for corporate charters, drawing intense attention from Delaware and increasing attention from corporate dealmakers and corporate law academic analyses. Activist investors sought a corporate law attuned to their agenda and sought (unsuccessfully) first that Vermont and then (successfully) that North Dakota accept their agenda. Although that state has captured few reincorporations yet—and, hence, little in franchise fees—the North Dakota development potentially constrains Delaware, even if that constraint is only a loose one now. The North Dakota scenario highlights how severe state competition could break out:  not from an aggressive, innovative legislature (a mode usually thought to be unlikely and, hence, one of the reasons we’ve seen state competition as weak), but from disgruntled Delaware corporate players who instigate another state to enter the fray.

And, third, Washington, D.C. has always been a corporate governance player. In the scandals of the early part of this decade and the economic turmoil of the latter part, its role in potentially displacing and often enough affecting state lawmaking has become increasingly vivid. The early part of this decade saw Congress pass the Sarbanes-Oxley Act, a major corporate law statute. The end of the decade sees the Securities and Exchange Commission considering a major restructuring of corporate law that would give disgruntled shareholders access to their company’s proxy solicitation apparatus in a way that could shift corporate law authority in the firm.

Each of these three channels deserves further attention. For the first channel—the intensity of corporate turnover in the real economy, impelling Delaware to have to scramble to sell new charters just to stay even—data I obtained from the Delaware Secretary of State’s office show flow and turnover of Delaware’s tax base to be substantial in the past decade. Although ongoing state-to-state competition for chartering revenues is somnolent, as has been shown, competition in American business—in the real economy—is not. Preexisting Delaware-chartered firms merge, restructure, or close, thereby eliminating in each case one source of Delaware’s franchise fees. To keep up, Delaware must draw new firms into the state. The raw chartering numbers show that about 10% of the chartered firms at the beginning of each year are gone by the end of the year. And, typically, 10% of the firms at the end of the year are new firms that Delaware has drawn in. The dynamism of the real economy interacts with the structure of the chartering market to create a major arena where Delaware must continually vie for charters.

The data reveal another trend: just as we corporate law academics were coming to the conclusion that state chartering competition wasn’t happening, this pressure on Delaware to maintain flow has increased. Briefly put: only a couple of decades ago, the half-life of Delaware’s tax base was on the order of a quarter century. That posed a real consideration for Delaware, but was long enough not to be of immediate concern to the typical career state official, legislator, or local lawyer. This pressure has intensified, however—due to increasing pressures coming from the real economy interacting—to reduce the half-life of Delaware’s tax base down to a decade.

Delaware must continually provide enough value to new firms arising in other states (and to their controlling decisionmakers) to induce them to reincorporate into Delaware. The current focus on whether state lawmakers are sufficiently dynamic and competitive is surely warranted, but potentially overemphasized. Even if states are insufficiently dynamic and competitive, American business is dynamic. Firms arise, prosper, and merge. Others arise, fail, and disappear. For Delaware’s importance to persist over the decades, it must convince new firms to reincorporate away from their home states.

Second, Delaware faces other constraints. We can call those constraints competitive ones, if we expand our concept beyond ongoing competition for chartering revenue. Or we might just think of them as pressures and constraints preventing Delaware from being a fully free agent in its corporate decisionmaking, due to potential competition. Delaware must be wary of making a major mistake, one that would not just induce the inflow to dry up, but that could induce a new, previously inactive state to enter the market, conceivably in a way that could irreversibly erode Delaware’s existing base of charters if corporate America becomes unhappy with Delaware (or one that arrests the flow of firms that reincorporate into Delaware). Even states not actively seeking charters today can potentially compete in this limited sense with Delaware. Such a concept has a parallel in the industrial organization literature on contestable markets: a single producer can putatively dominate a market, but could lose its market share overnight. Hence, it acts like a competitor on some matters, or knows it must provide an overall package that is attractive to its primary customers. It has slack, but that slack is not unlimited, because its market, like Delaware’s, is contestable.

In this dimension, the focus on slow state bureaucracies and uninterested state legislatures is justified but easy to overemphasize. Thus, the second major constraint on Delaware is that the relevant actors who could undermine Delaware’s lead would be the interests already in Delaware. If they became unhappy with Delaware, it’s corporate players who would push another state to actively seek corporate charters. Corporate interests are not passive consumers, forced by the absence of another state purveying its own corporate law to accept whatever Delaware decides to offer. They can lobby another state’s lawmakers, ask for new law, offer that state the tax benefits of the law, and do the initial legal work; they are the ones who would motivate and press Delaware to change. And, as if to demonstrate this possibility, shareholder activists, unhappy with Delaware law, went shopping for a friendly state in the past couple of years and found one—North Dakota—to put competitive pressure on Delaware.

Delaware, despite not facing the intense Economics 101 competition of many other producers of corporate law, faces a contestable market, and that contestability limits the breadth of Delaware’s discretion. Its position is contestable horizontally, subject to several powerful interstate pressures. And it’s also contestable vertically, subject to pressures from Washington, the third major channel confining Delaware’s range of discretion. For example, Delaware legislation passed in March 2009 could seriously change core parts of corporate law dealing with election contests and access to the company’s proxy statement. That legislation is best understood as motivated by one or the other, or both, of these horizontal and vertical dimensions to competition.

That Delaware competes in some sense seems indisputable: its principal lawmakers are active, involved, and energetic. Indeed, as one inside commentator tells us, even if Delaware has won some race or another, “no one in Delaware is willing to play hare while some other state tortoise gains ground.” Delaware players worry. They don’t face day-to-day, head-to-head competition with other states for corporate chartering revenue, as we now know. But they are not free agents. Their actions are constrained.

Acknowledgments:

Copyright © 2010 Stanford Law Review.

Mark J. Roe is the David Berg Professor of Law at Harvard Law School.

This Legal Workshop Editorial is based on the following Article: Mark J. Roe, Delaware’s Shrinking Half-Life, 62 STAN. L. REV. 125 (2009).

This topic is of more than academic interest.  My subject—how the corporate law and governance rules of our states interact with each other in a federal system—bears importantly on the efficient operation of the American economy.  In this current economic environment, this is a subject that concerns us all.

In this short Editorial, I will cover three topics.  First, I will outline the historical background behind the current model of how state corporate laws are supposed to interact.  Second, I will discuss how reality has come to diverge from the model, as a result of attempts to give state corporate law extraterritorial reach through the internal affairs doctrine and corporate outreach statutes.  Finally, I will attempt to answer the “so what?” question:  What are the practical implications of this divergence, and what do they spell for the future?

 
I.
Historical Development of the Model

As I said earlier, our federalist model resembles a patchwork of fifty separate bodies of state corporate law, plus the corporate law of the District of Columbia, all overlaid by an additional body of federal law.  By “corporate law,” I mean state statutes and judicial decisions that regulate internal corporate matters such as the forming of a corporation, the powers and duties of officers and directors, corporate elections, the rights of stockholders, the corporate decisionmaking process, corporate mergers, sales of assets, and the like.  “Corporate law” must be distinguished from “commercial law,” which is the body of rules that governs the corporation’s external economic relationships with parties outside the corporate family, such as suppliers and customers.

A key characteristic of this corporate federalist model is that a state’s corporate law governs only those corporations that are formed under that particular state’s corporate law.  The main reason for this is historical:  Until the twentieth century, all American corporate law was local.  In fact, until the late nineteenth century, state corporate statutes did not even exist; to form a corporation in any state, a special act of that state’s legislature was required.  This regime was problematic because it tethered economic expansion to access to the political system.  Eventually, the requirement that corporations be created by special legislative acts was jettisoned, and in its place, the states adopted general corporation laws that allowed any citizen who followed the prescribed statutory rules to form a corporation privately.

A second important feature of the late nineteenth century federalist model was that the reach of state corporate law was local¾that is, each state’s law stopped at the state boarder.  Again, the reasons were historical:  Except for a few giant multistate operations such as Standard Oil, U.S. Steel, and the large railroad companies, most corporations chartered under the new state statutes—their officers, directors, stockholders, and business operations—were located in a single state. Not surprisingly, any disputes involving these corporations’ internal affairs were governed by local state corporate law, and the resolution of those disputes affected, by and large, only the citizens of that state.

During the twentieth century, however, this model changed.  In the 1930s, as we know, the New Deal added a second, overlying layer of newly enacted federal law to remedy dislocations caused by the failure or inability of state law to keep up with changes in our national economy.

This new federal scheme fundamentally altered the original legal model.  Whereas before 1934 there had been one layer of regulation, after 1934 there were two.  Each layer operated independently of the other and with different functions.  Although most internal affairs of corporations continued to be regulated by state law, now some were removed from the state law domain and transferred to the federal.  Capital raising and other interstate transactions in corporate securities became, and have continued to be, governed by a separate body of overriding and preemptive federal law.

I now turn to the second topic, which is how the corporate federalist model and reality have come to diverge over the past seventy years.  In metaphorical terms, the question is how, in defiance of the theory of federalism, it became possible for one state’s corporate law to cross over that state’s boundary line and, in unforeseen ways, influence business activity that other states arguably had an interest in regulating.

 
II.
The Model and the Reality Diverge

This divergence between the model and reality has taken three quite different forms.  The first form of divergence resulted from what some refer to as the “first generation” of anti-takeover statutes; the second resulted from the widespread application of the internal affairs doctrine, which for generations has been a central feature of American corporate law; and the third resulted from the so-called “corporate outreach” statutes, which are exemplified by legislation adopted in California and New York.  I will discuss the second and third forms here.¹

 
A.     The Internal Affairs Doctrine

The internal affairs doctrine is a judge-made choice-of-law rule that mandates that disputes regarding “internal affairs”—“those matters which are peculiar to the relationships among or between the corporation and its . . . directors, officers and shareholders”²—are governed by the laws of the state of incorporation.  Illustrative examples of internal affairs include the mechanics of incorporating, the election or appointment of officers and directors, the adoption of bylaws, the issuance of shares and bonds, voting, mergers, the reclassification of shares, and the declaration and payment of dividends.

Extraterritoriality is an unavoidable consequence of the internal affairs doctrine.  As an example, imagine a company that is incorporated in Iowa.  A lawsuit involving that corporation’s internal affairs (say, a breach of fiduciary duty action) is filed in a New York state court.  In that lawsuit, the New York court will apply the internal affairs doctrine and decide the case under Iowa corporate law, even if the director-defendants all live in Illinois, or the plaintiff-shareholder lives in Wisconsin, or both.  By virtue of this choice-of-law principle, the corporate law of the state of incorporation has extraterritorial effect.

At first blush, this fact may appear to have only theoretical interest and no real-world importance; however, this is not the case, because the internal affairs doctrine does not exist in a vacuum.  It operates conjointly with two real-world facts.  First, internal affairs disputes frequently involve large corporations that have far-flung operations.  Second, a majority of those firms are incorporated in one state, namely, Delaware.  In practice, because of these facts, mega-disputes involving the internal affairs of America’s largest companies are often resolved under Delaware law.  And because of the large number of Delaware corporate law cases, Delaware corporate jurisprudence has become more widespread and more developed than the corporate jurisprudence of other states.  As a result, Delaware corporate law has come to have significant extraterritorial effect.

 
B.     The Corporate Outreach Statutes

The corporate outreach statutes adopted by California and New York have extraterritorial reach because they legislatively overrule the internal affairs doctrine and impose their own, often different, internal governance requirements upon foreign corporations having a specified level of contact with the forum state.³ I will focus on the California outreach statute, not only because it is the most illustrative, but also because it has actually been a subject of litigation.  Section 2115 of the California Corporations Code requires certain foreign corporations to conform to a broad range of California internal affairs requirements.  It provides that in cases where it applies, California corporate law will govern a host of internal governance matters.  These include the annual election of directors, the removal of directors, the filling of director vacancies in specified circumstances, the directors’ standard of care, the directors’ liability for unlawful distributions, the indemnification of directors and officers, and many others.  Lest there be any doubt about its intended purpose, the statute specifically provides that in cases where it applies, “the foreign corporation’s articles of incorporation are deemed amended to the exclusion of the law of the state of incorporation.”⁴

These outreach statutes are an effort, through legislation, by one state to give its corporate law extraterritorial reach.  Foreign corporations that are subject to these statutes risk being caught in a crossfire between two conflicting sets of governance requirements¾one imposed by the outreach statute of the forum state and the other mandated by the corporate law of the state of incorporation.  Because a corporation cannot obey two conflicting legal commands at the same time, the “hot button” question is which state’s corporate law will take precedence.

That issue has been litigated in both California and Delaware, and the results thus far have been a mixed bag.  In California, some court decisions have upheld the application of California governance requirements to corporations that had major California contacts but were incorporated elsewhere.⁵ In Delaware, the courts have held that by virtue of the internal affairs doctrine, Delaware corporate law trumped the conflicting California statutory rules.⁶ The question is ultimately one of constitutional law.  As the law currently stands, there is no single answer because the answer in any particular case depends upon which state’s jurisprudence¾Delaware’s or California’s¾a court looks to when deciding that question.

This brings me to my third and last topic.  We now know that a state’s corporate law may reach beyond its borders even though under the corporate federalist model it should not.  We also know that two of the three ways under which this can happen could set, at least potentially, a collision course that may affect more than just the two states whose corporate laws are in conflict.  The question becomes:  how will this uncertain state of affairs unfold in the future?

 
III.
What Will the Future Look Like?

In guessing what the future may hold, there are several possibilities, but they all turn on one question:  whether the internal affairs doctrine is only a choice-of-law rule or whether it is also a rule of constitutional law.  If the doctrine is only a choice-of-law rule, then any state is free to adopt or reject it.  If it is a principle of constitutional law, then no state is free to reject it.  The only court that can decide that question with finality is the United States Supreme Court, and thus far, the question has not percolated up to that level.

Language in some earlier Supreme Court decisions suggest that the Supreme Court has already recognized the constitutional dimension of the internal affairs doctrine.⁷ In addition, I personally subscribe to the view that the stability and certainty afforded by the internal affairs doctrine justifies according that doctrine constitutional status.  But my personal view is of minimal relevance.  The question is debatable, and legal commentators have lined up on both sides of the debate.⁸ So, any prediction about how the nation’s highest court might rule would be hazardous.  It is more productive, in my opinion, to tease out what might happen under both scenarios.

 
A.     The Internal Affairs Doctrine as a Choice-of-Law Rule

Let us first assume that the Supreme Court decides that outreach statutes such as California’s are constitutional.  Should this occur, I predict that the legislatures of other states will adopt their own outreach statutes, at the behest of shareholder activists and other interest groups.  Those statutes would likely impose various, perhaps highly idiosyncratic, kinds of corporate governance requirements upon foreign corporations that do business in those states.

Were that to happen, what would the landscape look like?  I suspect it would resemble a corporate law version of the “Gunfight at the O.K. Corral.”  Companies that do business in several states could find themselves subject to inconsistent internal governance requirements.  Were these conflicts to become widespread and frequent, it could become economically disruptive.  Corporations facing the impossibility of complying with two or more inconsistent governance requirements might simply choose not to do business in the states having inconsistent rules—a choice that could distort economic incentives and seriously inhibit economic growth.  Or, corporations might instead choose to create separate subsidiaries to operate in each state in which they do business.  Creating new levels of corporate ownership may solve the inconsistency problem, but it would inflict other costs such as (not limited to) additional taxes and increased cost of capital.

Were this state of affairs to become sufficiently disruptive, it could create pressure for Congress to eliminate the conflict by enacting some kind of preemptive uniform legislation.  The least intrusive form of such legislation—that is, the kind that would preserve the states’ authority to regulate corporations chartered under state law—would just mandate the internal affairs doctrine on a nationwide basis, in effect overturning our hypothetical Supreme Court decision upholding outreach statutes.  The most intrusive¾that is, the kind that would be least protective of state sovereignty¾would be a federal corporation law that would displace the corporation law of all fifty states.  For those of us who have devoted our professional lifetimes to shaping and improving corporate governance law at the state level, that would be a most unfortunate development, if only because it would create rigidity and retard experimental (and, hopefully, beneficial) change.  Experience shows that laws enacted by Congress, even if flawed, are politically difficult, if not impossible, to change.  In contrast, imperfect laws that are enacted by state legislatures or imperfect rules crafted by judges as part of the common law adjudication process tend to be more easily correctible.

 
B.     The Internal Affairs Doctrine as a Rule of Constitutional Law

Now, assume the alternative scenario:  The Supreme Court decides that the internal affairs doctrine is also a rule of constitutional law.  In that event, the corporate outreach statutes would be invalid, at least as applied to a foreign corporation whose state of incorporation imposes inconsistent requirements.  There would be a clear, easily applied rule that regardless of where a lawsuit involving the corporation’s internal affairs is filed, only the law of the state of incorporation governs the case.  That would essentially preserve the status quo, but it is important to keep in mind that the status quo is not necessarily static or quiescent.  Far from it.  For years, other states have been competing with Delaware, and with each other, to encourage firms either to incorporate or to reincorporate in their jurisdictions. If the internal affairs doctrine were to become the universal rule, that competition could well intensify.

By way of example, beginning in the 1980s, thirty-one states, including Pennsylvania, Virginia, and Rhode Island, adopted so-called “other constituency” statutes.  These statutes did two things.  First, they relieved target company boards responding to takeover bids from any obligation to treat the interests of shareholders as paramount over all others.  Second, they permitted those boards to consider the effects of a hostile takeover on other constituency groups, such as employees, suppliers, customers, creditors, and local communities. Essentially, these statutes were a legislative rejection of Delaware case law, specifically the Unocal⁹ and Revlon¹⁰ decisions, which imposed greater limitations upon how directors may respond defensively to hostile takeover bids.

If the Supreme Court were to constitutionalize the internal affairs doctrine, absent preemptive federal legislation, we could expect more and different forms of this kind of competition among states for incorporation business and the franchise tax income it generates.  That is, in an internal affairs doctrine world, there would be competition among state legislatures, but there would be no irreconcilable direct conflicts imposed on individual firms.  Different states would offer different arrays of legal choices, and corporations would choose whatever legal regime they preferred, just as they do now.

Acknowledgments:

Copyright © New York University Law Review.

The Honorable Jack B. Jacobs is a Justice of the Delaware Supreme Court.

This Legal Workshop Editorial is an abbreviated version of the following Lecture: Jack B. Jacobs, The Reach of State Corporate Law Beyond State Borders: Reflections Upon Federalism, 84 N.Y.U. L. REV. 1149 (2009). The original Lecture was delivered on February 26, 2009 at the New York University School of Law as the 15th Annual William J. Brennan, Jr., Lecture on State Courts and Social Justice.

The first two contests have already been carefully dissected in the academic literature.  This Editorial seeks to offer a partial solution to the third problem:  the civil war between majority and minority shareholders.  Several incongruous Delaware cases, the rise of private equity, and a flood of post-Sarbanes-Oxley freezeout mergers have underscored the need for lawmakers to confront the governance problems presented in this context.

The tension between majority and minority shareholders is especially interesting because lawmakers must walk a tightrope between two alternative hazards.  On the one hand, granting the majority shareholder untrammeled discretion can promote abuses of power that will depress the ex ante value of a firm.  Controlling shareholders enjoy many strategies for fleecing minority investors, but none are more potent than using a freezeout merger to take full ownership of the firm.  It is easy to see how an overly permissive freezeout policy might lower a firm’s market value:  Potential investors will fear that a controlling shareholder might price the merger at a ridiculously low level.  This fear will, in turn, depress the upfront price that minority investors would be willing to pay for the stock.

On the other hand, assigning too much power to minority shareholders can lead to a holdout problem, with recalcitrant dissenters demanding private payouts before blessing a beneficial merger.  Even if minority owners do not maintain an express veto over the transaction, generous remedial statutes or very strict standards of review present a risk of costly strike suits.  The legal challenge, of course, is how to balance the dual extremes of majority expropriation and minority holdout.

 
I.
Regulating Freezeout Mergers

Thus far, corporate law has dealt with the majority-minority governance problem, as it appears in the merger context, through a troika of regulatory policies.  First, under federal securities law, firms undergoing a freezeout merger must disclose detailed financial information to all shareholders.  Second, freezeout mergers are subject to judicial review (often in Delaware) to determine whether the firm’s directors or controlling shareholders have breached a fiduciary obligation to the minority owners.  And third, dissenting shareholders may have the right to file an appraisal claim, which theoretically ensures—again through a judicial proceeding—that minority owners receive fair value for their shares.  In a perfect world, these protections should act in concert to get the balance right.

Unfortunately, this three-part framework has not been very satisfying in practice.  Disclosure seems like a reasonable idea, but it often does not have much practical effect and is subject to loopholes.  Judicial review of fiduciary duties in freezeout mergers is messy, at least in Delaware, because inconsistent standards attach to similar economic transactions:  Courts will either adopt a strict “entire fairness” standard or award defendants the protection of the deferential “business judgment rule” depending on whether the deal is structured as a statutory merger or a tender offer.  And the appraisal remedy has long been criticized as a weak cure due to its stringent (and outdated) procedural requirements and its protracted use of costly adversarial litigation to value shares.

So if the current legal framework is not working, how should we deal with the freezeout problem?  Are there other sensible ways to divide the levers of power between majority and minority shareholders to help deter abusive deals and facilitate sensible ones?  Better yet, can we create rules that encourage firms to make reasonable tradeoffs themselves, using private contractual arrangements instead of costly judicial resources?

 
II.
Reframing Freezeouts as a Cathedral Problem

Except for the ubiquitous Coase Theorem,¹ there may be no more famous law and economics framework than Guido Calabresi and Douglas Melamed’s “view of the cathedral.”² This line of scholarship—dealing with the design, allocation, and transfer of legal entitlements—shows how rights can be protected either through property rules or liability rules.  Property rules vest the legal entitlement in one party, who may then sell that entitlement to another party if she wishes, but who cannot be required to sell it.  Liability rules, by contrast, allow the second party to force the first party to sell the entitlement at a judicially determined price.  Under either rule, the entitlement should end up with the party who values it most.

The freezeout problem can be perfectly mapped onto the cathedral framework by conceptualizing the right of minority shareholders to block a freezeout—or, alternatively, the right of a majority controller to conduct one—as a legal entitlement.  A property rule would unconditionally award minority owners the right to block a freezeout merger, which is effectively what the unanimous merger voting requirements of the early 1900s accomplished.  A liability rule, by contrast, gives the entitlement to conduct a freezeout merger to the majority shareholder, subject to the dissenting minority shareholders receiving a judicially determined price under appraisal.  The switch from unanimous shareholder voting to majority rule with appraisal rights can thus be understood as a move from a property regime to a liability regime for freezeouts.

This model is helpful in the freezeout context because recent work in this area has started to show how it is possible to parse legal entitlements even more finely.³ Instead of adopting a strict property or liability rule for freezeouts, we should consider intermediate strategies where embedded options are used as a form of mechanism design to award partial rights to each side.  If successful, this compromise might help to balance the dual concerns of holdout and expropriation by smoking out the concealed subjective valuations that form the heart of the freezeout problem.

The main idea is to replace a naked entitlement with a conditional one where the party receiving the entitlement has an obligation to write the other parties their own option as an additional part of the exercise price for the entitlement.  For example, a factory could be given a liability entitlement to pollute on neighboring land, but only if it writes the neighbor an option to purchase this entitlement at a strike price reflecting the factory’s subjective valuation of this right.  In other words, a privileged party is not just an option taker but also an option maker.  This means that those not receiving the entitlement would be allowed (and may be willing) to “buy back” the right under certain conditions.  The ultimate goal is to move away from judicial determination of an entitlement’s value by encouraging the parties to set private mechanisms (embedded options) that elicit their relative subjective values.  That is, laws are used not to allocate or price an entitlement, but rather to persuade private parties to expose their subjective valuations.

 
III.
Pressing an Internal Poison Pill

Along these lines, I believe that a new type of economic instrument can better balance the tension between majority and minority shareholders in the freezeout context.  I call it an “internal poison pill”—in obvious reference to the antitakeover device that famously sets the balance of power between target firms and third-party acquirers in the hostile takeover context.  An internal poison pill is similar to its cousin in that it seeks to craft economic disincentives to the trampling of the rights of impacted shareholders (minority owners in this context) as a way of restoring balance to merger deliberations.  Indeed, a traditional “external” poison pill (with only slight modifications) might be used to address this problem, although this is not the approach that I ultimately recommend.

Instead, I argue that a more flexible, though weaker, “internal” pill can offer a better compromise than the conventional medicine.  The focus of my proposed modification is on the power of redemption.  The main trick is to use embedded options to qualify the pill’s de facto veto power.  For example, as a requirement for exercising the pill’s discounted call option, minority shareholders would be required to write the triggering controlling shareholder an embedded option setting a price under which the minority shareholders’ poison pill rights could be redeemed.  Economic incentives (what I call a “catch”) should also be adopted to discourage the minority shareholders from demanding outrageous terms—such as requiring a redemption payment of $1,000,000 per share.  The procedures and economic incentives of this “internal” pill are more complex than those of a conventional pill; the easiest way to understand how it would work is to set out the basic design in the form of an extended example.

Start with the most elementary of freezeout scenarios.  A firm is divided among thirty-one owners:  a majority controller holding seventy shares and thirty minority owners, each holding one share.  The controller wants to conduct a freezeout and offers $55 per share ($5 above the prevailing market price of $50), conditioned on the tender of at least twenty shares, which would give the controlling shareholder 90% of the shares and unlock the use of a short-form merger to buy the other shares.  Some subset of the minority owners resist this transaction, arguing that the shares are worth more.  One of two things is happening here:  (1) $55 is a fair price and the dissenters are jockeying for more than they deserve; or (2) the shares really are worth more (perhaps because the market price is depressed by threat of expropriation), and the controller is attempting to pay less than she should.

Historically, the 70% owner enjoyed a unilateral option to execute the merger—subject only to the dissenting shareholders’ willingness to file a fiduciary duty lawsuit or seek appraisal rights.  Suppose, however, that the firm has an “internal” poison pill.  This pill contains three main features:  the primary call, the embedded redemption option, and the catch.

 
1.     The Primary Call

Under an internal poison pill, each shareholder receives the right—typically through the issuance of convertible preferred stock—to obtain additional common shares for a discounted price (which I will assume here to be zero for simplicity) if the pill is triggered through a control acquisition (i.e., the contemplated freezeout).  The pill discriminates against the triggering acquirer, however, and she is precluded from exercising her primary call.  So far, then, the pill operates exactly like the “flip-in” feature of a conventional poison pill by making it painfully expensive for the acquirer to trigger these rights.  If five shareholders sell their shares to the controlling shareholder, for instance, the collective stake of the other twenty-five owners doubles to fifty shares, hamstringing the controlling shareholder’s position.

 
2.     The Embedded Redemption Option

Importantly, however, the internal pill also includes an embedded redemption option.  Before suffering any dilution, the controlling shareholder enjoys an opportunity to disarm the pill by redeeming the preferred stock rights.  Any minority shareholder seeking to exercise the primary call must pay a price (in addition to the discounted strike price):  He must write a return option to the triggering controlling shareholder allowing her to redeem the pill by purchasing his common stock at a price set by that minority holder.  For example, “pushover” shareholder A may set a price of $56, “average” shareholder B may set a price of $60, and “hardball” shareholder C may set a price of $100.  If the controlling shareholder is willing to buy any (or all) of these shares at those stated prices, then the attached poison pill flip-in right expires.  Of course, the controller is not obligated to redeem; she simply possesses that option.

The goal of this second feature is to elicit an honest statement from the minority shareholder of her valuation that can be compared to the controlling shareholder’s valuation of the freezeout.  If the shares in this example are really worth $60 (and shareholder B knows this), then B can set his reservation price at $60 through the pill redemption option.  The majority shareholder can then work her way up from the lowest to the highest redemption price and decide whether to buy a 90% stake, which would trigger short-form merger rights.  (There is another important ramification of exceeding this 90% threshold, which I will discuss momentarily.)

 
3.     The Catch

There is one final problem that has perhaps already crossed your mind.  What prevents all minority shareholders from acting like shareholder C, selfishly demanding a very high redemption price in order to keep their pill armed, thereby blocking the merger?  Indeed, greedy shareholder D could set a redemption price of $1,000,000 to virtually assure himself that the controlling shareholder will not redeem his pill.  The third feature of our internal pill, then, needs to address this problem by placing a “catch,” or ceiling, on a minority shareholder’s temptation to exaggerate his subjective value.

This potential solution comes from an insight of mechanism design:  In order to elicit honest valuations, the minority holder must be placed under a veil of ignorance—unaware of whether he will have to buy or sell at his stated price.  Specifically, to mitigate the greedy shareholder problem, the internal pill should contain one last feature:  If the majority shareholder reaches or exceeds the 90% ownership threshold (or, conceivably, some other preset target), then all remaining preferred stock dissolves, and the controlling shareholder gains the right (but not the obligation) to sell shares to each remaining minority shareholder at exactly the price that each minority shareholder just demanded in the redemption option.  This is really just a conditional put option with the price set at the dissenter’s stated valuation.

Giving the controlling shareholder the protection of this catch should discourage minority dissenters from naming outrageous redemption terms.  The controlling shareholder will begin to buy shares (and simultaneously redeem pills) from minority shareholders—starting at the lowest named price and working her way up to a 90% (or more) stake.  She can then force a sale of extra shares on greedy overreachers.  In our earlier example, the controlling shareholder might buy ninety-one shares and sell that one extra share to shareholder D for $1,000,000.  Or, more likely, the threat of releasing the catch would preclude shareholder D from setting an outrageous redemption price in the first place.  After any catch sales are executed, the controlling shareholder can complete the short-form merger to take unified control.

If designed correctly, these (admittedly more complex) securities might be used to elicit and compare the subjective values that each party places on a transaction.  If the freezeout is a rip-off (because the majority shareholder has set an artificially low price), then the internal pill would have bite, and the minority shareholders could receive additional discounted shares—or, more likely, the majority shareholder would not attempt the abusive freezeout in the first place.  If, on the other hand, a minority shareholder is simply stonewalling a sensible deal, he will be unwilling to put his money where his mouth is for fear of springing the catch, and the majority shareholder can economically redeem the internal pill.  This three-part internal pill may seem overly complicated at first, but my longer Article explains the detailed mechanics of the pill and works through a few short scenarios that quickly elucidate the inner gears and springs of the idea.⁴

 
IV.
Concluding Thoughts

Even if the internal pill works as designed, it is fair to ask why a firm would ever wish to implement one.  Indeed, we might expect majority shareholders to resist vehemently any effort to water down their current freezeout prerogative with a more restrictive governance regime.  Yet there are at least three possible reasons to adopt the pill:  (1) It may be in the majority shareholder’s economic interest to do so as a form of precommitment that would increase the value of the company’s stock; (2) private gadfly shareholders or advisory organizations may lobby for the pill; or (3) the law could evolve to encourage or require firms to adopt internal pills.

One of the more exciting developments in economic theory posits that incentive-molding rules can corral parties toward optimal social ends strictly by appealing to their rational self-interest.  If these ideas can be put into practice, it may become possible for policymakers to craft intermediate legal entitlements—somewhere in between the property and liability rules of Calabresi and Melamed—that promote welfare-enhancing substantive outcomes without large administrative costs or expensive litigation.

The device is not flawless, however, and inside information or colluding dissenters may undermine the effects of an internal pill.  Moreover, powerful controlling shareholders could resist adoption efforts.  But there are strong theoretical justifications for promoting internal pills as an improved form of corporate governance.  Lawmakers should consider donning the white coat of pharmacists in order to improve the incentives that influence the ongoing balance between public and private corporate status.

Acknowledgments:

Copyright © 2009 New York University School of Law.

George S. Geis is the John V. Ray Research Professor of Law at the University of Virginia School of Law.

This Legal Workshop Editorial is based on the following Article: George S. Geis, Internal Poison Pills, 84 N.Y.U. L. REV. 1169 (2009).

I.

Minority shareholders typically play an active role in closely held corporations, but, if serious differences arise, majority shareholders have the power to call the shots, including whether to employ minority shareholders and whether to declare dividends.  Absent additional bargained-for rights, minority shareholders may find themselves unemployed and frozen out of any return on their investment.  Unlike shareholders in public corporations, minority shareholders cannot protect themselves by selling their stock and exiting the corporation.  There is no public market for close corporation stock, by definition, and who would be willing to buy a minority interest in a business after the shareholders have had a falling out?

In order to salvage their investment, minority shareholders may seek judicial intervention.  However, because claims of minority shareholder oppression involve the standard features of a close corporation—majority control and locked investment—courts face a dilemma.  If they revise central terms of the relationship after the fact to avoid perceived unfairness to minority shareholders, courts diminish the viability of the close corporation as a distinct form of business organization.  For that reason, some courts refuse to recognize any doctrine of shareholder oppression, observing that corporate law permits minority shareholders to bargain for desired protections before investing.¹ In a majority of jurisdictions, though, courts either borrow the heightened fiduciary obligations of partnership law, holding controlling shareholders to a higher standard than would be required under corporate law, or provide relief to the extent a minority shareholder’s “reasonable expectations” have not been met.²

Taken at face value, each of these standard approaches is flawed—either too quick to dismiss the specific challenges faced by the minority in a close corporation or else too willing to impose vague obligations on the majority.  But there is also a procedural aspect to the evaluation of claims of oppression.  Often, controlling shareholders can assert a plausible business justification for conduct that disadvantages the minority and the underlying facts will be hard to ascertain.

In close cases, as a practical matter, the outcome may depend more on the level of scrutiny applied by the court in deciding whether the minority’s claim of oppression has merit than on any divergence in the substantive standard for oppression.  Thus, whether the core obligations of controlling shareholders are understood primarily in contractual or fiduciary terms, it independently matters how hard the court will look to see if the obligations have been met.  Unless a court places some burden on the majority to substantiate its proffered justification, the minority shareholders will almost certainly lose.

II.

Despite its importance, the procedural dimension of minority shareholder litigation has received little notice.³ The level of scrutiny instead seems to correlate with the substantive standard in a particular jurisdiction, reflecting either a relatively permissive or strict attitude toward the majority’s right to enjoy the benefits of control.  The procedural and substantive questions can be disaggregated, however.  I argue that courts should embrace this flexibility and should use minority “voice” to set the appropriate level of scrutiny.

Flexible judicial scrutiny based on voice would improve existing approaches to shareholder oppression, allocating pleading or production burdens to the party best able to meet them.  If the minority lacks a voice in the business—in other words, a meaningful opportunity to review information relevant to important corporate governance decisions and to participate in the decisionmaking process—courts should apply enhanced scrutiny, accepting general pleadings and requiring controlling shareholders to establish a legitimate business purpose for challenged conduct. When adjudicating claims of shareholder oppression in close corporations with substantial minority participation—paradigmatically, representation on the board of directors—courts should apply more relaxed scrutiny, giving substantial deference to the majority’s business judgment absent evidence of self-dealing or bad faith.⁴

Although it might seem odd to focus on voice when the more pressing issue for minority shareholders, in the event of a freeze out, is lack of exit, the two problems are connected.  The foundation of my argument is Albert Hirschman’s classic insight that exit and voice are interrelated mechanisms and that economic and political responses to a firm’s decline may be complementary.⁵ For example, regular customers at a restaurant may complain of bad service, if they think that will help; if service does not improve, they can shift from voice to exit and take their business elsewhere.  Given the restrictions on exit in a close corporation, minority shareholders must rely on voice to protect their interests when potential conflicts arise.  The proposed voice-based framework would offer close corporations an incentive to include substantial minority input in corporate governance decision making, and it would guide judicial analysis when litigation cannot be avoided.

III.

In the article, I identify three major objections to the proposed voice-based framework.  First, why not attack the problem of oppression directly by creating an enhanced right of exit for minority shareholders? Second, and related, why worry about minority shareholder voice when, at the end of the day, the majority still has the power to make the decisions? Third, since shareholders have the ability to bargain for desired protections, or to choose a different form of business organization, why give minority shareholders a voice option they did not bargain for?

Admittedly, an automatic right of exit would seem to simplify matters by eliminating the need for complex liability determinations.  Professors Matheson and Maler, for example, have proposed a statutory right of exit akin to a no-fault divorce.⁶ My principal concern is that creating a right of exit would undermine the significance of the close corporation form and the shareholders’ interest in having a locked investment.  If corporate law rules can be circumvented without even a showing of fault, the distinction between a partnership and a close corporation will be lost.  To the extent choice of form has value, the loss of a meaningful choice is a cost to consider.

It also seems unclear whether an automatic exit right would actually reduce the cost of litigation.  Given the lack of an established market for shares, creating liquidity for close corporations involves considerable valuation difficulties.  Under existing doctrine, there must be a showing of harm before any remedy is available, which limits litigation and focuses those lawsuits that do go forward on liability issues that courts are better suited to address.  Even if no-fault exit promises some efficiency benefits, those savings may not amount to much because litigating valuation will also be expensive.

Moreover, minority shareholders could gain too much power in the governance of the close corporation.  While some boost in exit could enhance voice by backing it with a credible threat, the possibility of shareholder litigation may already serve that function.  If the threat of exit becomes too strong, given the need for locked investment, then minority shareholder demands may overwhelm sensible decision making.  (For similar reasons, the problem of oppression cannot be solved via mandatory voice-enhancing mechanisms like veto power or super-majority voting because those mechanisms, too, would shift power to the minority, creating a risk of deadlock or the extraction of rents to avoid holdout problems.)

However, my modest insistence that minority shareholder voice is important to the health of close corporations and should guide the intensity of judicial scrutiny leaves me open to a different kind of objection—that voice, as I define it, has no practical value.  Allowing a minority shareholder to have her say and then outvoting her is, for all practical purposes, the same thing as just outvoting her.  The problem with the objection is that it conflates voice with voting.

Although majority shareholders ultimately decide all contested questions, voice is a political mechanism and need not be synonymous with control.  A person’s ability to participate and to be heard on issues important to a shared enterprise, whether family, business organization, or nation-state, does not turn on the final tally of votes.  Voice is not as crude a mechanism as exit; its value lies in its nuance, as a means of shaping the goals of a close corporation to better accommodate the interests of all shareholders.  Corporate decisions based on transparent, open discussion will more often serve the interests of all shareholders and the minority will more likely accept the results of an inclusive, deliberative process as fair.

Finally, some scholars may object that voice-based scrutiny would disregard the choice of business form made by the parties, altering the bargain they thought they had.  The objection is misplaced.  The proposed framework does not change substantive doctrine or impose a new fiduciary obligation; rather, to the extent controlling shareholders are already prohibited from appropriating the value of the minority’s investment, I contend that courts should place the burden on the party best able to meet it.  A more flexible, voice-centered model of judicial scrutiny would better serve the interests of minority shareholders and the close corporations to which they belong.

Even if the proposal could be understood to restrict the ability of parties to customize control arrangements, because minority voice determines the level of judicial review, the choice-of-form objection would remain unconvincing.  One of the distinguishing features of corporate law is the mandatory fiduciary duty of loyalty owed by controlling shareholders to the corporation—directly or by dint of their control of the board of directors.  If investors want to sharply limit fiduciary duties, perhaps in favor of enhanced, contractual exit rights, the choice-of-form theory indicates that they should pick a partnership or limited liability company form more amenable to contractual modification.

Acknowledgments:

Copyright © 2009 Georgetown Law Journal.

Benjamin Means is Assistant Professor of Law at University of South Carolina School of Law.

This Editorial is based on the following full-length Article:  Benjamin Means, A Voice-Based Framework for Evaluating Claims of Minority Shareholder Oppression in the Close Corporation, 97 GEO. L.J. 1207 (2009).

The high profile controversy over the rise of SWFs and their shift to equity investments is one—but only one—of  the frictions that result from the interaction of two very different conceptions of the role of government in a capitalist economy—what  we term the new mercantilism versus market capitalism.  In the form of market capitalism that has developed in the advanced economies, to be sure with fits and starts, the individual company is the unit whose value is maximized.  Prohibitions against government subsidies and preferences reflected in WTO rules and those of the European Union are designed to prevent governments from shifting the level of profit maximization from the company to the state.  In contrast, some major developing countries (China foremost among them) increasingly reflect a form of state capitalism—what we call the new mercantilism—in which the country is the unit whose value is to be maximized, with a corresponding increase in the role of the national government as a direct participant in and coordinator of the effort.  For the developed economies, the belief that free trade and competition at the company level increases GDP at the national level is an article of faith: the market polices the tautology.  For developing economies, the state, acting through institutions like SWFs, through direct ownership of operating companies, and through regulation, seeks to level the playing field.  For the new mercantile capitalism, the government attempts to ensure that company-level behavior results in country-level maximization of economic, social, and political benefits. 

Although SWFs constitute only one mechanism of state involvement in the economy, they have attracted great attention because for some commentators they are the current face of this tension between competing forms of capitalism.  Governments are now accumulating stakes in what were purely private entities.  As one commentator argues, “these trends [in the growth of SWFs and their investment activities] . . . involve a dramatic increase in the role of governments in the ownership and management of national assets.  This characteristic is unnerving and disquieting.  It calls into question our most basic assumptions about the structure and functioning of our economies and the international financial system.”³ 

Looking behind the rhetoric, SWF investments have attracted attention as a result of two factors, one economic, the other tied to national regulation.  On the economic side are the large accumulations of government wealth SWFs represent, together with changes in how this wealth is invested.  The great success of Asian exporting nations and the rapid rise in oil prices have dramatically increased the foreign currency reserves of nations with trade and commodity based economies.  China’s foreign currency reserve of $1.4 trillion is mentioned almost daily in the U.S. media.  Private analysts estimate that with oil prices at the now-modest level of $70 per barrel, $2 billion of new petrodollars enter world financial markets every day.⁴ 

Also, reserve-rich countries have begun to change their investment strategy. Until recently, these surpluses were invested heavily in U.S. treasury securities and other national government bonds.  Capital was recycled without economic or political disruption.  That pattern has changed—for economic reasons, not due to changes in international relations or foreign policy.  Many governments have recently announced plans to shift investment strategies for sovereign assets from conservative holdings of government bonds to higher-risk/higher-return investments in equities or corporate acquisitions.⁵  The announced reason for these changes in portfolio strategy is straightforward.  Reserve-rich countries are seeking the higher returns and greater diversification associated with investing in a broader range of asset classes. 

The result has been a boom in high profile, and highly controversial investments.  A few examples include the Abu Dhabi Investment Authority’s (“ADIA”) recent acquisition of Citibank debt convertible into 4.9 percent of its common stock, which would make ADIA one of the bank’s largest shareholders, and the purchase by another Abu Dhabi entity of 8.1 percent of the common stock of Advanced Micro Devices, a U.S. chipmaker with Defense Department contracts.  Somewhat less controversially, but no less significantly, SWFs have recently made multi-billion dollar investments in U.S. investment banks such as Citigroup, Morgan Stanley, and Merrill Lynch, whose capital was depleted by the meltdown in the subprime mortgage market.

The regulatory reason for the controversy over SWFs is slightly more nuanced.  The tension between new mercantilist- and market-versions of capitalism is playing itself out in two very different kinds of equity investments.  The first is acquisitions of controlling stakes in domestic companies by operating companies owned by or affiliated with foreign-government entities.  Although the national regulatory mechanics differ, virtually all major countries, including the United States, already have regulatory protections in place to guard against threats to national interests which take the form of acquisitions of control.⁶

The current controversy over SWFs, and our attention here, concerns a second kind of equity investment: the acquisition of significant, but non-controlling, stakes in domestic companies by portfolio investors affiliated with foreign governments.  For example, all of the SWF investments noted above are of this second type, and only a small number of SWFs pursue investment strategies involving control acquisitions of foreign companies.  At present, there is no specific regulation of portfolio investments by foreign governmental entities at the national or multilateral level.  Yet even ostensible portfolio investments of minority stakes on the part of foreign entities are said to pose a variety of problems, including most provocatively a national security concern raised by a minority shareholder’s potential to influence a company’s actions.  In response, the United States, the European Union, Germany, and the United Kingdom have all taken up the call for a regulatory response.  Proposals have ranged from widespread demands for increased disclosure and transparency, to restrictions on the types of equity instruments in which SWFs may invest, to calls for multiple-round, multilateral negotiations.⁷  The European Commission recently recommended to the European Parliament and other EU agencies the shape of a common EU approach to SWFs, including detailed governance and disclosure requirements.⁸  The international lending organizations have also taken up the call, with the IMF, for example, calling for a code of best practices for SWFs.⁹

But calls for good corporate governance and transparency, however useful in their own right, do not address the legitimate concern, but of which there is so far no observed example, that some SWFs may invest for strategic, non-economic, rather than economic, motives.  A thoughtful response to the SWF controversy requires that we clearly recognize the tension between the two very different faces of ostensibly non-controlling equity investments by foreign government entities.  In fact, voluntary codes of conduct and transparency simply cannot effectively distinguish between SWFs making traditional economic investments and those making, or transforming existing positions into, mercantilist investments.

Viewed from one side, SWF investments are simply a different means of recycling trade surpluses through the capital market.  This new source of equity investments provides liquidity to the equity markets and lowers the cost of equity for private corporations, just as foreign government investment in U.S. debt instruments has reduced long-term U.S. interest rates (by an amount recently estimated as 130 basis points).¹⁰  Moreover, the withdrawal of foreign government investments from the equity market may be less of a strategic threat than if the investments had remained entirely in U.S. government debt; equity need not be refunded.  The recent capital infusions provided to Citigroup, Morgan Stanley, and other U.S. financial institutions also softened the effects of the subprime mortgage crisis.

The other face of foreign sovereign equity investments is the source of the controversy.  Viewed from this side, national security concerns anchor one end of a continuum of circumstances when the interests of a foreign government, and therefore of the SWF, may differ from those of an ordinary shareholder.  Consider again SWFs’ rapid infusion of capital into U.S. commercial and investment banks in the wake of the subprime write downs.  Few domestic financial institutions provided capital.  If the investment opportunity was attractive in purely economic terms, why were the SWFs the principal investors?  Perhaps the investments were attractive to SWFs because they got something more than a purely financial investment.  Or perhaps SWF investments were particularly attractive to the current managers of the investment banks struggling with subprime write downs because they could act quickly and were thought unlikely to agitate for change, an unusual combination of characteristics for investors in companies whose operating strategies created the need for massive capital investments in the first place. 

The point is that an SWF’s investment motives are not transparent regardless of the extent of its formal disclosure—its public statements, reports or filings.  Suppose that pursuant to a new requirement of an NGO-promulgated code of best practices, an SWF states that it operates entirely independently of its government owner.  Why would anyone believe the statement, since even if true in the past, it will be true in the future only if the government so chooses.  In effect, the government owner always retains the option to behave strategically.  Could anyone genuinely believe that the investment managers of China Investment Corporation or Singapore’s Temasek would hang up the phone if a senior government official called to offer advice on the fund’s handling of a particular investment to the end of advancing the country’s, rather than the portfolio company’s, interests?  Additional disclosure or pledges of independence simply cannot distinguish between economic and mercantilist investors.

Efforts to diffuse this tension between the benign and threatening faces of sovereign wealth fund equity investments requires a strategy of regulatory minimalism, one that does not spill over beyond addressing the potential conflict of interest between the foreign government and ordinary shareholders to impair the critical capital market benefits that flow from recycling large trade deficits.  This is where corporate governance enters the analysis:  policing conflicts of interest among participants in the firm—for SWFs, where the sovereign investor’s interests are different than those of the other shareholders—has always been a central focus of corporate governance regimes.

A simple corporate governance fix provides the needed minimalist approach.  We propose that equity of a U.S. firm acquired by a foreign-government-controlled entity would lose its voting rights, but would regain them when transferred to non-state ownership.  This voting suspension separates the ability to influence control from investment value.  The expected returns to a foreign sovereign equity investor remain identical to those of other shareholders; an SWF would both buy and sell voting shares.  It would lose only the direct influence over management through voting and the indirect influence that the threat of voting provides.  Sovereign investors with purely economic motives will still invest; the proposal does not raise the cost of or lower the returns from their investments.  Sovereigns seeking mercantilist benefits from equity investments, however, will find SWFs to be a less attractive vehicle by which to achieve their ends.  This adjustment mitigates the potential conflict of interest concern that animates the SWF debate without telling sovereign governments the way they should organize and operate governmental entities.

Some might perceive our proposal as protectionist.  But to do so is to misconstrue the impact of vote suspension.  Vote suspension is protectionist only in the sense that it operates on the frictions between competing versions of capitalism; market-based capitalist regimes are protected against incursion by new mercantilist regimes.  But unlike a truly protectionist measure designed to protect domestic companies’ commercial interests rather than the integrity of the structure of a form of capitalism, our proposal would not lower investment values for foreign investors on account of their nationality or sovereign affiliation per se.  Moreover, we fully anticipate that other countries would respond by imposing reciprocal treatment on investment funds controlled by U.S. government entities.

Our proposal is not a perfect solution to the tensions raised by SWFs.  It is under-inclusive in that influence can be exercised by means other than voting; a significant shareholder need not always cast a vote to sway management.  It is also over-inclusive in that even regulatory minimalism will spill over to unintended areas.  As just noted, we expect that countries whose SWFs are subject to the vote suspension rule in the United States would respond in kind; thus, U.S. state investment funds such as the Alaska Permanent Revenue Fund (among the largest SWFs in the world) may be treated reciprocally by other countries.¹¹  Despite its imperfections, vote suspension does serve to constrain a major source over concern over SWF investment without creating a barrier to recycling trade surpluses. 

To be sure, vote suspension does not (and is not intended to) address the more deeply rooted and significant frictions that arise from the interactions of different capitalist systems, which do involve issues of real protectionism.  However, it does effectively address the high profile concern over SWFs that, left unaddressed or addressed too broadly, has the potential to seriously disrupt the global capital market through heavy handed regulation and protectionism.

Acknowledgments:

Copyright © 2009 Stanford Law Review.

Ronald J. Gilson is Stern Professor of Law and Business, Columbia Law School; Meyers Professor of Law, Stanford Law School; Fellow, European Corporate Governance Institute.

Curtis J. Milhaupt is Fuyo Professor of Japanese Law & Professor of Comparative Corporate Law, Columbia Law School; Director, Center for Japanese Legal Studies at Columbia Law School.

This Editorial is based on the following full-length Article:   Ronald J. Gilson & Curtis J. Milhaupt, Sovereign Wealth Funds and Corporate Governance: A Minimalist Solution to the New Mercantilism, 60 STAN. L. REV. 1345 (2008).

Now imagine if the sale of securities were to operate in the same fashion. That is, suppose securities were sold on an “as is” basis where purchasers were afforded little information and no recourse. Should this be allowed? Prevailing policies and case law dictate that it should, so long as the purchaser is a sophisticated investor bargaining in a face-to-face transaction.

In fact, such securities transactions have been occurring with increasing frequency in recent years with the advent of big boy letters.  Big boy letters are agreements between parties to a securities transaction where one party, typically the seller, has material, nonpublic information that it does not want to disclose, but both parties want to complete the transaction and preclude any claims based on the nondisclosure of the nonpublic information.  The party with superior information will ask for a big boy letter precisely because of this claim waiver clause, in an effort to protect itself from Rule 10b-5 liability.  By signing a big boy letter, the signatory agrees not to rely on the any of the counterparty’s nondisclosures and to waive all claims against the counterparty arising out of the nondisclosure.  The signatory also acknowledges that it is financially sophisticated and that it realizes the effect of the waiver and elects to proceed with the transaction, essentially stating, “I am a big boy.”

At first glance, it appears the eBay bidder has a distinct advantage over the signatory of a big boy letter.  At least the eBayer receives some information, no matter how vague and incomplete, whereas the big boy signatory seems left in the dark.  Crucially, though, this is not so.  Just as the “as is” tag acts a warning to the bidder, so, too, does a big boy letter.

Suppose that Seller and Buyer, both sophisticated parties, initiate a discussion for the sale of securities.  At the very outset, Seller alerts Buyer that the latter will need to sign a big boy letter to carry out any such sale.  Immediately, Buyer realizes several key points.  That Seller is asking for a big boy letter notifies Buyer that Seller has nonpublic information and that such information is material to the sale.  If neither of these were true, there would be no need for a big boy letter in the first place.  Moreover, that Seller is looking to trade the securities, combined with the fact that Seller has material, nonpublic information, signals to Buyer that the information that Seller has must be adverse.  If the nonpublic information was indeed positive, Seller would surely hold the securities until the good news materialized, so that Seller could reap the benefits.

Consequently, the disparity between the two parties is not as great as it first seems.  Buyer receives a strong, albeit somewhat noisy, signal about the material, nonpublic information—similar to the vague and incomplete information delivered to the eBay bidder.  This quasi-disclosure, coupled with the sophistication of the parties, discharges any duty to disclose that Seller may have, while still complying with Rule 10b-5 jurisprudence.

Ultimately, the sophisticated party who buys securities with a big boy letter is in a better position than the eBayer who buys items “as is.”  The former can investigate the public issuer of the securities to gain more information and can negotiate for more favorable contractual terms.  Short of visiting the seller and inspecting the item in question, a near-impossibility with eBay auctions, an eBay bidder has no choice but to proceed on whatever information it is given at whatever price the market has set on whatever terms the seller has offered.

Regardless, this does not answer the normative question posed at the outset.  Should big boy letters be allowed in the first place?  We are in the midst of an economic crisis caused, in great part, by a series of risky maneuvers where too few considered the dangers or the overall effects of their actions.  The sophisticated parties referred to here—institutional investors such as investment banks and insurance companies—infamously made numerous such missteps.  Are we to allow them to trade securities with one another in a system rigged by information asymmetries where buyers have no recourse?

Yet, for the same reason that the market for “as is” items on eBay operates smoothly, the market for securities traded with a big boy letter operates smoothly as well, and it will continue to do so.  On eBay, the decision to bid on an item or not² and the final auction price³ of an item are both appreciably influenced by a seller’s feedback rating—essentially its reputation.  The feedback mechanism “reduce[s] opportunistic behaviors by screening participants and monitoring transactions,” acting as a proxy for trustworthiness.⁴  The market for “as is” items functions properly because, like any other market on eBay, the transaction is generally between honest participants who are incented not to cheat or mislead in order to generate positive feedback (or at least to avoid negative feedback).⁵

It is interesting to note that, despite the prevalence of big boy letters and their officially unresolved legal status, there has only been one private law suit concerning them.  The circumstances surrounding big boy letters reveal an explanation for this phenomenon.  Big boy letters are contracts between sophisticated parties who are repeat players in the financial markets negotiating face-to-face.  As such, these parties must act with integrity to protect their brand and reputation.  Therefore, the signatory may not be able to afford the reputational costs of going back on its word by suing the counterparty, just as the counterparty may not be able to afford the reputational costs of fraudulent or misleading behavior.  The paucity of cases on big boy letters seems to indicate that they do indeed implement this sort of market discipline.  In the financial industry, trust and reputation are arguably a firm’s most valuable assets.

To be sure, buyers certainly face risk when purchasing securities with a big boy letter.  At the same time, all securities transactions are inherently risky, even when both parties have perfect information.  Buyers realize these risks and do not undertake big boy transactions lightly.  Furthermore, the sophisticated party’s knowledge, experience, bargaining power, and competent counsel all mitigate the risks involved.  In the end, it is not the role of the SEC or the government to regulate the substance of a trade or to prevent bad or risky investments.  This does not mean that the SEC ought to ignore big boy letters altogether.  In my note, Big Boy Letters: Trading on Inside Information, I identify three areas of concern regarding big boy letters and propose rules and policies that the SEC ought to consider.  However, in this instance, the calculated judgments of sophisticated parties bargaining at arm’s length and with ready access to counsel ought to be left alone.

Acknowledgments:

Copyright © 2009 Cornell Law Review.

Edwin D. Eshmoili is a J.D. Candidate at Cornell Law School. He received his B.S. from Binghamton University in 2006.

I am indebted to Osamu Watanabe for inspiring me to write on this topic. I am grateful to Joshua C. Teitelbaum and Jonah Fecteau for their insights and guidance. I appreciate my colleagues on the Cornell Law Review for all their assistance. Most of all, I thank my family and friends for their love and support.

This Editorial is based on the following Student Note: Edwin D. Eshmoili, Big Boy Letters: Trading on Inside Information, 94 CORNELL L. REV. 133 (2008). Click Here for the Full Student Note

Contemporary corporate case law and scholarship, however, pay far more attention to corporate officers’ and directors’ duties than to those of shareholders.  Officers and directors are understood to owe fiduciary duties of loyalty and care that are broad and deep, constraining their every material business decision.  Shareholders, in contrast, are thought to have far more limited obligations.  In fact, outside the narrow contexts of closely-held companies and self-dealing by majority shareholders, many commentators assume shareholders have no duties at all.  Minority stockholders in public companies are often viewed as free agents, at liberty to try to influence corporate policy as they see fit—including trying to influence corporate policy in ways that favor their own interests over those of the corporation and other shareholders.

Why has the possibility that minority shareholders in public firms might use their power in self-serving ways attracted so little attention?  First, until recently minority shareholders have played a largely passive role in public companies, with the result that minority shareholders in public firms have been perceived as having far less power to set corporate policy than directors and officers have.  The second reason why the question of minority shareholders’ duties has been largely overlooked is that, even when minority shareholders do try to take an active role in public companies, it has been generally believed that their primary goal is to improve the firm’s overall economic performance—an interest that is closely aligned with both the interests of the firm and the interests of other shareholders.  Shareholder activism, accordingly, has been assumed to be a beneficial influence.

Both of these assumptions are becoming increasingly inaccurate.  The economic and legal contexts in which American public corporations do business are changing swiftly in ways that create a pressing need to reexamine conventional notions of shareholder duties.  As a result of recent developments in the financial markets, in business practices, and in corporate law, minority shareholders are finding it economically rational to try to influence corporate decisionmaking.  The long-standing assumption that public company shareholders lack the ability or incentive to engage in activism is no longer accurate.

Meanwhile, even as shareholders are becoming more powerful, their interests are becoming more heterogeneous.  Increasingly, the economic interests of one shareholder or shareholder group conflict with the economic interests of others.  The result is that activist shareholders are using their growing influence not to improve overall firm performance, as has generally been assumed, but to profit at other shareholders’ and at the firm’s expense.

We believe fiduciary duty doctrine can and should be interpreted in a new way that takes into account changes in the corporate landscape and reaches such opportunistic behavior.  Indeed, we believe that the law of fiduciary duty is uniquely suited to address the growing problem that opportunistic shareholder activism poses for corporate governance.

 
I.
A Primer on Shareholder Fiduciary Duties

Fiduciary duties are usually applied to officers and directors.  In some cases, however, courts impose fiduciary duties of loyalty on certain types of shareholders as well. When they do, the analysis tends to follow the application of loyalty duties in officer and director cases.

In particular, courts have held that majority shareholders, like corporate officers and directors, owe a fiduciary duty of loyalty to minority shareholders that precludes them from using their positions as controlling shareholders to extract material economic benefits from the firm at the minority’s expense.  As articulated by the California Supreme Court in the famous case of Jones v. H.F. Ahmanson & Co.,¹ “Majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority.  Any use to which they put the corporation or their power to control the corporation must benefit all shareholders proportionately . . . .”²

As in the case of corporate officers and directors, courts deem corporate actions that provide unique benefits to controlling shareholders to be potential violations of controlling shareholders’ duties of loyalty.  As in the case of corporate officers and directors, such actions are not utterly prohibited.  A controlling shareholder can escape liability by proving, to the court’s satisfaction, that while a transaction was tainted by a conflict of interest, it was nevertheless intrinsically fair to the firm and other shareholders. Also as in the case of officers and directors, courts assessing the fairness of controlling shareholders’ transactions initially put the burden on the controlling shareholder to establish the intrinsic fairness of the deal, in terms of both process and price, to the corporation and its minority investors.

Finally, courts have found that some bargaining procedures contribute so substantially to a finding of intrinsic fairness that, if those procedures are followed, the court will shift the burden back to the plaintiff to prove that the transaction, despite the fairness of the procedures surrounding it, involved substantively unfair terms.  This is particularly clear in controlling shareholder cases where a suspect transaction after full disclosure was approved by “a majority of the minority,” meaning a majority of the remaining minority shareholders who did not have a conflict of interest.

 
II.
Theoretical Foundations of Limited Shareholder Duties

It thus appears that, at least in certain cases, courts subject shareholders to loyalty duties similar in nature to the loyalty duties imposed on corporate officers and directors.  Nevertheless, most contemporary discussions of fiduciary duty in public corporations continue to orbit around officers and directors.  This can be explained in part by the fact that shareholders in public corporations historically have been passive investors, not active participants in corporate governance.  This passivity stemmed not only from the “public good” nature of shareholder activism (a minority shareholder who seeks to improve corporate performance must bear all the costs of the activism while sharing any resulting benefits with all the firm’s other shareholders) but also from traditional corporate law rules of proxy voting which made it difficult and expensive for shareholders to attempt to exercise meaningful corporate power.  To the extent that shareholders in public corporations were unable, as a practical matter, to influence corporate policy, one can understand why the question of shareholder fiduciary duties has been neglected.  As one commentator has put it, “There is no need for concern about the oppressive propensities of persons who lack the power of implementation.”³

A second reason why shareholder duties have not attracted much attention is the common belief that, even in the rare case when a minority shareholder tries to take an active role in corporate decision-making, that activism benefits both the corporation and other shareholders.  According to this view, minority shareholders want to make the corporation as profitable as possible in order to maximize the value of their shares.  To the extent they accomplish this objective, they serve not only their own interests but those of the other shareholders as well. This theory of uniform shareholder interest independently renders fiduciary limits on shareholder action unnecessary.

Taken together, the assumptions that shareholders in public firms are mostly passive and that shareholders share common interests have led many observers to conclude that shareholders, unlike corporate officers or directors, are not generally bound by fiduciary duties.  In particular, existing law on shareholder fiduciary duties can be interpreted as limiting shareholder duties in at least two important ways.  First, cases often seem to suggest that only “controlling” shareholders are subject to the duty of loyalty, while “non-controlling” shareholders may vote as they please without objection that their motives are for personal gain. Second, courts have tended to find even controlling shareholders subject to fiduciary duties primarily in two limited business situations: corporate “freezeouts” and close corporations.

 
III.
Shaking Foundations: The Rise of Minority Shareholder Power

Changes in markets, business practice and business institutions, and in corporate and securities law have seriously eroded the realism of the conventional wisdom that minority shareholders are passive and powerless. 

First, recent decades have seen the rise of institutional investors—typically pension funds and mutual funds—that aggregate the savings of millions of individuals into enormous investment portfolios that buy stock in public companies.  A number of prominent institutional investors, including both mutual funds like Fidelity and Vanguard and pension funds like CalPERS, have emerged as activist investors willing to mount public relations campaigns, initiate litigation, and launch proxy battles to pressure corporate officers and directors into following their preferred business strategy.

Second, shareholders’ ability to influence policy in public companies received an important boost in 1992 when the SEC amended its federal proxy regulations for the express purpose of permitting large shareholders to exercise their voting power more effectively. The 1992 amendments exempted from the definition of a regulated “proxy solicitation” most shareholder communications not actually accompanied by a formal proxy solicitation, and also made clear that most shareholders were free to make public statements, including speeches, press releases, and internet communications. The 1992 amendments thus made it much easier for investors—including institutional investors and hedge funds—to coordinate with each other and combine their individual holdings into a single, much larger voting block.  It also became much easier for shareholders to communicate with other shareholders, and with the general public, concerning their views on corporate policy.

Third, another recent development that has magnified shareholders’ collective influence is the creation of commercial “shareholder advisory services.”  Shareholder advisory firms specialize in advising pension funds and mutual funds, for a fee, how to vote the proxies of the shares held in their investment portfolios.  As a result, advisory services coordinate the voting policies of many different institutional investors, effectively aggregating their shares into one large voting bloc controlled, as a practical matter, by the advisory service itself. By far the largest and most influential shareholder advisory service today is Institutional Shareholder Services (ISS).  The emergence of ISS as the dominant advisory service thus has dramatically reduced the collective action problem traditionally thought to plague shareholders in public firms. The widely dispersed individual shareholders who once routinely voted with corporate management have been replaced to a great extent by institutions that follow the advice of a single and far more independent-minded “voter”—ISS.

Fourth, perhaps the most important development in recent years contributing to greater shareholder activism is the rise of new type of institutional shareholder for whom activism is especially economically attractive—the hedge fund.  Hedge funds are lightly-regulated investment pools that cater to wealthy investors, and so are exempt from most of the disclosure requirements and other legal burdens borne by mutual funds that take investment funds from the general public. Many hedge funds typically do not attempt to diversify their portfolios, but instead take large positions in as few as two or three companies, and then demand that those companies pay special dividends, launch massive stock buyback programs, sell assets, or even put themselves on the auction block in order to add “shareholder value.” The popularity of hedge funds has grown enormously in recent years, and by some estimates by 2008 hedge funds controlled as much as $2 trillion in assets.  The result is a new genre of public company shareholder that is aggressive, wealthy, and eager to play a role in setting corporate policy. 

Fifth, yet another factor promoting greater shareholder activism is financial innovation.  Today investors purchase not only stocks and bonds but also various alternative hybrid forms of equity, debt, and derivative instruments. Financial innovation encourages shareholder activism in at least two ways.  First, it creates more incentives for activism, because the more complex a company’s capital structure becomes, the more opportunities are presented for investors who purchase one type of security to push for corporate actions that harm the value of another type of security issued by the same company.  For example, a preferred stockholder in a troubled firm might push for an asset sale to trigger its liquidation preference, while common shareholders demand a risky strategy that could raise the value of the common if it succeeds but harms the value of the preferred.  A second and more widely recognized reason why financial innovation has encouraged shareholder activism is that it has lowered the cost of activist strategies by allowing the separation of voting rights and economic interests.  Thus, a hedge fund can buy a block of common stock and vote the shares while simultaneously entering a derivatives contract that hedges away its economic interest in the stock.  Indeed, the fund can take a negative economic position in the firm by shorting its stock and then seek to profit from using its power as a formal shareholder to push for business policies that drive stock price down.

These are only a few of the recent developments that have worked in tandem to shift power in public corporations away from executives and boards and into the hands of activist shareholders.  Other recent or proposed changes—the possible adoption of a “proxy access” rule by the Securities Exchange Commission, the New York Stock Exchange’s proposal to eliminate “broker voting,” the rapid adoption of “majority voting” rules in director elections at many large public corporations, the institution of electronic “e-proxy” voting—all promise to give activist shareholders even more influence over corporate policy.  Not only have minority shareholders become far more powerful, the trend shows every sign of continuing.

 
IV.
Shaking Foundations More: The Problem of Shareholder Conflicts of Interest

As shareholders are becoming more powerful, they are also becoming more heterogeneous.  Activist shareholders can have serious conflicts of interest with other shareholders arising from (1) their other relationships with the firm; (2) their investments in derivatives or securities issued by other corporations; and (3) their investments in other parts of the firm’s capital structure.

The dangers of shareholder self-interest are perhaps most apparent in the case of self-dealing transactions between the firm and the shareholder.  Corporate law has long viewed with suspicion transactions between the firm and a controlling shareholder.  Yet as minority investors in public companies have acquired more power, it has become clear that an activist minority may also have enough clout to push through interested transactions.  The high-profile proxy battle to remove Steven Burd as Chairman and CEO of Safeway Inc. provides an example of how activist investors can use their shareholder status to push for favorable treatment in their other dealings with the firm.  Burd was taking a hard-line stance in labor negotiations with the United Food & Commercial Workers Union (UFCWU), which represents grocery workers.  The California Public Employees’ Retirement System (CalPERS), a large pension fund representing California employees, organized a proxy campaign to remove Burd from the corner office.  It was soon revealed that the CalPERS campaign had been initiated by CalPERS’ President, Sean Harrigan, who was also a career labor organizer and an official of the UFCWU. 

A second common situation where conflicts of interest between activists and other shareholders in the firm can arise is when activist shareholders take “adverse positions” in derivatives or in securities issued by other companies.  For example, an activist can become a formal shareholder with voting power while simultaneously either “shorting” the company’s shares, or entering a derivatives contract to hedge away its economic interest.  Activists can also take adverse positions in the securities of another company.  They can even combine both types of adverse interest.  A widely-cited example of this involved the potential purchase of King Pharmaceuticals by Mylan Laboratories.  Hedge fund Perry Capital, which had recently purchased nearly ten percent of Mylan’s common stock, supported the acquisition, although industry observers perceived the deal as overpriced.  Perry turned out to have a good reason to want Mylan to overpay for King.  Perry was also a large shareholder in King, and it had used a derivatives contract to hedge away its economic interest in the Mylan shares it had purchased.  Thus Perry stood to make money if the deal went through even if Mylan’s shares declined, as bidding companies’ shares often do in mergers. 

Yet a third source of conflict between shareholders in public firms is the increasingly complex capital structure of American corporations.  Consider the case of DiLillo v. Ustman Technologies, Inc.⁴  Hedge fund Sagaponack Partners invested $7 million in a small environmental services company called Ustman Technologies.  In exchange, Sagaponack received high-interest notes and 40 percent of the company’s common stock.  According to their terms, the notes were soon converted into preferred stock with a liquidation preference of $17 million that could be triggered by the sale of substantially all the company’s assets. Only two years after making its initial $7 million investment, Sagaponack invested another $750,000 to increase its equity ownership in Ustman to 48.5 percent of common shares.  At this point, Sagaponack used its influence over Ustman’s board to cause the company to sell substantially all its assets to a third party for $17.3 million.⁵  All the proceeds from the sale went to pay Ustman’s debts and Sagaponack’s liquidation preference, with nothing remaining for the common shareholders.

Although Sagaponack held such a large block of Ustman common stock that it was arguably a controlling shareholder subject to loyalty duties—indeed, this is why a lawsuit was filed and the conflict of interest came to light—DiLillo illustrates how an activist investor can profit from taking a position in one type of security issued by a company and then using the control rights associated with that security to push for corporate action that diminishes the value of that security but increases the value of another type of security issued by the same corporation in which the activist investor has an even large economic interest.  Although for a number of reasons it is very difficult to get hard data on how often minority activist shareholders, especially unregulated hedge funds, face these sorts of conflicts of interest, anecdotal reports suggests that it may be common for activists to take positions in more than one type of security issued by the same company.⁶

 
V.
Using Fiduciary Duties to Address Activist Shareholder Conflicts of Interest

Taken together, the two trends of shareholders becoming both more powerful and more divided point to a serious rise in the risk of shareholder opportunism.  Corporate law can address this increased risk through the relatively straightforward mechanism of applying corporate fiduciary duties to shareholders more broadly.

In particular, activist shareholder overreaching can be deterred by (1) interpreting loyalty duties to apply not only to controlling shareholders, who can dictate board decisions in all matters, but also to activist minorities who succeed in influencing management with respect to a single transaction or business decision, and (2) applying shareholder fiduciary duties not only in the traditional contexts of freezeouts and close corporations, but in any factual situation where a shareholder reaps a unique personal economic benefit to the detriment or exclusion of other shareholders.

 
VI.
Expanding the Notion of “Control”

Corporate fiduciary duties exist to restrain self-interested behavior by persons in a position to exert control over the corporate entity.  Existing case law already applies this principal not only to corporate officers and directors, but to majority shareholders as well, and in some case to shareholders deemed to exercise “de facto” control over the corporation’s board of directors.

We believe shareholder control should viewed not a binary inquiry (either a shareholder has “control” or it does not), but as a spectrum of power and influence.  At one end of the spectrum lies the sole shareholder who holds 100 percent of a firm’s outstanding voting stock and enjoys complete authority over the firm and its board of directors. At the other end there is the rationally apathetic, atomized individual investor who cannot be bothered to return a proxy by mail.  Between these two extremes lies a vast range of possible allocations of power between individual shareholders and directors.  Indeed, more than one shareholder or shareholder group can be said to “control” the firm in some fashion.

The inquiry into whether or not a shareholder has control for purposes of activating the latent duty of loyalty is accordingly best framed as an inquiry into whether a particular shareholder can, formally or informally, influence corporate behavior with respect to a particular issue.  Any attempt to exercise influence that produces the desired result—put differently, any shareholder act that is a “but for” cause of some corporate transaction or strategy—is an exercise of de facto control.

This formulation goes beyond the scope of the traditional shareholder control test in two important ways.  First, it is context-specific, meaning it determines whether a shareholder is a controlling shareholder by referring to the role that the shareholder played with respect to a particular corporate decision.  If a minority shareholder influences a particular corporate action, such as a decision to declare an extraordinary dividend, in a determinative way, it will have satisfied the control test with regard to that specific action. 

A second distinction between our definition of shareholder control and the existing test is that our formulation does not rely on the sort of arbitrary threshold for voting power that underlies current doctrine.  Our test would treat even a one percent shareholder as a controlling, if that shareholder’s assent was essential in determining the outcome of the vote at issue.  Indeed, our formulation recognizes that minority shareholders can exercise control even when they are not voting.  For example, a shareholder may be able to determine a board’s decision with regard to a particular matter—say, a share repurchase program—by threatening a proxy battle, or by undertaking an aggressive public relations campaign directed at the board. 

Traditional case law offers a basis for this expanded notion of shareholder control.  Smith v. Atlantic Properties, Inc.⁷ is an oft-cited case involving a corporation with four shareholders and a charter provision that required dividends to be approved by an 80 percent shareholder vote, giving each of the four partners an effective veto. After one shareholder had a falling-out with the other three, he steadfastly refused to approve dividends, either out of spite or a desire to minimize his personal tax liability.  The unfortunate effect was to trigger tax penalties on Atlantic Properties’ accumulated earnings.  The court found that the recalcitrant minority shareholder had violated his duty of loyalty to his fellow shareholders because the 80 percent provision had given the minority shareholder an “ad hoc” controlling interest.”

Although Smith v. Atlantic Properties is a close corporation case, its logic applies equally well to minority shareholders in public companies.  When a single shareholder’s actions determine the outcome—as when an activist successfully extracts greenmail, or a hedge fund with five percent of shares casts the deciding vote in a hotly-contested merger—that minority activist, like the minority shareholder in Smith v. Atlantic Properties, has exercised “ad hoc” control and triggered latent loyalty duties.

 
VII.
Expanding the Notion of When Shareholder Interests Conflict

In addition to expanding the idea of shareholder control, our approach would also expand shareholder fiduciary duties in a second fashion, by applying the duty of loyalty to any corporate transaction or strategy that provides one or more shareholders with a material pecuniary benefit not shared by other shareholders.  This approach rejects any claim that shareholder conflicts of interest arise only in freezeouts and close corporations, or that shareholder fiduciary duties should be limited to those contexts.  Instead, we propose a flexible approach that mirrors that typically taken in duty of loyalty cases involving corporate officers and directors.  Rather than trying to identify isolated instances which shareholder conflicts arise, our approach instead asks the larger question typically asked in director and officer fiduciary duty cases: Does the shareholder have any material economic interest that is different from other shareholders’ interests in the matter?

Despite the common pattern of courts applying shareholder fiduciary duties primarily in the freezeout and close corporation contexts, an open-ended and fact-specific approach to finding potential conflicts is consistent with corporate case law and especially with the seminal case of Sinclair Oil Corp. v. Levien.⁸  In Sinclair, the controlling parent corporation did not exploit the minority shareholders in its partially-held subsidiary by arranging a freezeout merger.  Rather, it used its control over the subsidiary to cause the subsidiary to sell petroleum products to itself on favorable terms.  Sinclair thus illustrates how, when presented with fact patterns that fall outside the standard freezeout context but nevertheless raise clear conflict of interest issues, courts have responded by imposing loyalty duties on controlling shareholders.

 
VIII.
Incorporating Traditional Loyalty Defenses

On first inspection, the suggestion that all shareholders should be subject to a latent fiduciary duty of loyalty might lead a casual observer to conclude the natural result will be an explosion of litigation.  This is not the case.  The practical scope of loyalty duties can and should be contained, and litigation confined to cases presenting real and serious conflicts of interest, through several restrictive measures.

One of the most important is to allow shareholders accused of breaching their duty of loyalty to use the affirmative legal defenses employed in cases involving officers and directors, defenses that have proven effective at discouraging frivolous litigation in that context.  One such protection is the plaintiff’s burden of alleging facts demonstrating that the shareholder defendant (1) in fact exercised influence that may have determined the outcome and (2) had a material economic interest in the outcome that differed from that of other shareholders.  The number of cases in which a plaintiff can make both showings is likely to be small, and also likely to involve circumstances where judicial scrutiny is appropriate and desirable.

Investors generally can use their formal shareholder status to influence corporations in three ways: (1) by voting; (2) by filing suit against the firm or its managers; and (3) by publicly seeking to embarrass or threaten incumbent management with a proxy fight or public relations campaign.  Very few shareholders engage in the last two activities, and those that do are exactly the activists on whom it is most desirable to impose loyalty duties.  Of course, all shareholders can vote.  However, only in the relatively rare case where a vote is hotly contested and the outcome determined by a small margin can a plaintiff allege the outcome was determined by the vote of a particular minority shareholder.

Even then, litigation cannot be sustained unless the plaintiff can also allege facts establishing that the minority shareholder in question had a material personal economic interest in the outcome.  This means that the plaintiff must allege facts supporting a specific conflict of interest of the sort discussed in earlier.  Only then, and only if the shareholder subject to the conflict exercised de facto control, can a suit can be brought—and it is then that judicial scrutiny is most needed.

Even when a plaintiff can demonstrate both exercise of de facto control and a material conflict of interest, the activist minority shareholder defendant retains an important escape route against liability.  That escape route is the traditional defense, available to officers, directors, and controlling shareholders accused of loyalty breaches, that although the transaction at issue was tainted by self-interest it was nevertheless intrinsically “fair” in terms of both price and process.  It is only if the transaction is unfair—again a situation where liability is appropriate—that the defendant shareholder will be held liable.

Finally, Section 144 of the Delaware General Corporation Law provides some defenses for corporate officers and directors who enter into interested transactions that might be extended to minority shareholders as well.  In particular, Section 144(a)(2) provides a defense to the director whose interested transaction is approved, after full disclosure of the material facts of the transaction and the conflict of interest involved, by a majority of the firm’s disinterested shareholders.  Case law has extended this defense to controlling shareholders, where it is called the “majority of the minority defense”—that is, the interested transaction with the majority shareholder was approved by a majority of the remaining minority shareholders.⁹  There seems no logical reason not to extend this defense to minority activist shareholders as well.

 
IX.
Conclusion: The Wisdom of Using Fiduciary Duties to Constrain Shareholder Opportunism

There is no reason to believe activist minority shareholders are immune to the same temptations of greed and self-interest that are widely understood to face corporate officers and directors.  Our proposed reinterpretation of shareholder fiduciary duties recognizes this reality.

Our approach has two advantages as a strategy for dealing with self-serving shareholder activists.  First, it brings existing fiduciary duty doctrine into line with the changing reality of how and why shareholders assert power in the corporate governance arena.  As a result, it offers a broad, flexible, and preemptive solution to the problem of shareholder overreaching.  This seems likely to be a far more effective approach than the sorts of ad hoc, after-the-fact responses to particular forms of abusive shareholder behavior that regulators have adopted in the past, and that prominent corporate law scholars continue to propose today. 

Second, we believe our reinterpretation of shareholder fiduciary duty can lend much-needed support to the controversial but increasingly influential normative claim that promoting “shareholder democracy” is a useful way to constrain managerial misbehavior.  In the wake of recent corporate scandals, firms and regulators have urged the adoption of a variety of changes in corporate law and practice designed to increase shareholders’ power to pressure the directors of publicly-held firms into adopting particular business policies, from requiring more independent directors to requiring shareholder votes on CEO pay.  Academics and investor interest groups are calling for even more “shareholder empowerment.”  Whether or not the modern trend of shifting corporate power toward shareholders and away from boards and executives will ultimately serve shareholders’ own interests depends critically on how individual shareholders and shareholder groups actually exercise their growing influence.  By limiting their ability to use it in opportunistic and self-serving ways, we hope to encourage a version of shareholder democracy that promotes, rather than destroys, shareholder welfare.

Acknowledgments:

Copyright © 2009 Stanford Law Review.

Iman Anabtawi is Professor of Law, UCLA School of Law.

Lynn Stout is Paul Hastings Professor of Corporate and Securities Law, UCLA School of Law; Principal Investigator, UCLA-Sloan Research Program on Business Organizations.

This Editorial is based on the full-length Article: Iman Anabtawi & Lynn Stout, Fiduciary Duties for Activist Shareholders, 60 STAN. L. REV. 1255 (2008). Click Here for the Full Article

This has been dramatically illustrated by the subprime crisis. The initial trigger of the cascade of failures that led to this crisis was the historically unanticipated depth of the fall in housing prices.¹ Loans to risky, or “subprime,” borrowers were often made with the expectation of refinancing through home appreciation. When home prices stopped appreciating, these borrowers could not refinance. In many cases, they defaulted.²

These defaults in turn caused substantial amounts of investment-grade securities backed by these mortgages to be downgraded and, in some cases, to default.³ Investors began losing confidence in these securities, and their prices started falling. Mark-to-market accounting rules and the high leverage of many firms exacerbated the fall.⁴

The refusal in mid-September 2008 of the government to save Lehman Brothers, and its resulting bankruptcy, added to this cascade. Securities markets became so panicked that even the commercial paper market virtually shut down, and the market prices of mortgage-backed securities collapsed substantially below the intrinsic value of the mortgage assets underlying those securities.⁵ Banks and other financial institutions holding mortgage-backed securities had to write down their value, causing these institutions to appear more financially risky, in turn triggering concern over counterparty risk.⁶

Although the federal government has taken numerous steps to address this collapse, including enacting the Emergency Economic Stabilization Act of 2008, most of its steps to date have focused on institutions, not markets.⁷ Such a narrow focus worked well when banks and institutions were the primary source of corporate financing. But as the financial crisis reveals, this focus is insufficient now that companies obtain much of their financing directly through capital markets.  

My article argues that institutional systemic risk and market systemic risk should not be viewed each in isolation. Institutions and markets can be involved in both. This integrated perspective is useful because a chain of failures of critical financial intermediaries, by definition, would significantly affect the availability and cost of capital. These failures, therefore, implicitly become a proxy for market consequences. In contrast, a chain of failures of institutions that are not critical financial intermediaries could only significantly affect the availability or cost of capital when those failures are large enough to jeopardize the viability of capital markets.

As disintermediation increases, therefore, systemic risk should increasingly be viewed by its impact on markets, not institutions per se.

 
I.
Analysis

My article focuses on regulating systemic risk. This is a subset of the problem of regulating financial risk. Scholars argue that the primary if not sole justification for regulating financial risk is maximizing economic efficiency. Because systemic risk is a form of financial risk, efficiency should be a central goal in its regulation.

Efficiency has a somewhat unique added dimension in the context of systemic risk. Without regulation, the externalities caused by systemic risk would not be prevented or internalized because systemic risk pertains to risks to the financial system itself. Market participants are motivated to protect themselves but not necessarily to protect the system as a whole. As a result, there is a type of tragedy of the commons, in which the benefits of exploiting finite capital resources accrue to individual market participants, each of whom is motivated to maximize use of the resource, whereas the costs of exploitation, which affect the real economy, are distributed among an even wider class of persons. Any regulation of systemic risk thus should focus not only on traditional efficiency but also on stability of the financial system.

In examining regulatory approaches to systemic risk, one should also take into account the costs of regulation. These can include direct costs such as hiring government employees to monitor and enforce the regulations, and indirect costs such as potential moral hazard. In identifying regulatory approaches, my article takes these costs into account, as well as the goals of efficiency and stability.

After reviewing historical approaches, my article concludes that attempts to regulate systemic risk can be imperfect and messy. Furthermore, the historical focus has been on bank systemic risk and related monetary policy. Modern models of regulating systemic risk should also focus on non-bank and market failures. The article includes these other failures in its focus.

To this end, the article identifies and critiques the following regulatory approaches.

 
A.     Averting Panics

The ideal regulatory approach would aim to eliminate the risk of systemic collapse, ab initio. Theoretically this goal could be achieved by preventing financial panics, since they are often the triggers that commence a chain of failures. I have separately argued that the subprime financial crisis itself was triggered by financial panic.⁸ Any regulation aimed at preventing panics that trigger systemic risk, however, could fail to anticipate all the causes of the panics. Furthermore, even when identified, panics cannot always be averted easily because investors are not always rational.

 
B.     Requiring Increased Disclosure

Another potential regulatory approach is to require increased disclosure. Disclosing risks traditionally has been viewed, at least under U.S. securities laws, as the primary market-regulatory mechanism. It works by reducing, if not eliminating, asymmetric information among market players, making the risks transparent to all.

In the context of systemic risk, however, individual market participants who fully understand that risk will be motivated to protect themselves but not the system as a whole.⁹ Imposing additional disclosure requirements may even prove counterproductive, causing market participants to change their behavior. For example, traders may become more cautious, demanding that prices move farther before making trades, thereby ultimately reducing market liquidity.

The efficacy of disclosure is further limited by the increasing complexity of transactions and markets. A contributing factor to the recent subprime crisis, for example, is allegedly that many institutional investors bought mortgage-backed securities substantially based on their ratings without fully understanding what they bought.

The article thus concludes that requiring increased disclosure would do relatively little to mitigate the potential for systemic risk.¹⁰

 
C.     Imposing Financial-Exposure Limits

The failure of one or more large institutions could create defaults large enough to de-stabilize other highly-leveraged investors, increasing the likelihood of a systemic market meltdown. This suggests another possible approach to regulation: placing limits on inter-institution financial exposure. Financial-exposure limits would facilitate stability by diversifying risk, in effect by reducing the losses of any given contractual counterparty and thus the likelihood that such losses would cause the counterparty to fail. Limits also might reduce the urgency, and hence the panic, that contractual counterparties feel about closing out their positions.

This approach already applies to banks through lending limits, which restrict the amount of bank exposure to any given customer’s risk. Its application beyond banks to other financial institutions is potentially appealing given the increasing blurring of lines between banks and non-bank financial institutions and the high volumes of financial assets circulating among non-bank financial entities.

It is questionable, though, whether the government should impose financial exposure limits on institutions. Large financial institutions already try to protect themselves through risk management and risk mitigation. The subprime crisis has raised questions, though, whether conflicts of interest among managers and other failures can undermine institutional risk management.¹¹

 
D.     Requiring Reduced Leverage

Requiring reduced leverage could reduce the risk that an institution fails in the first place. It also could reduce the likelihood of transmitting financial contagion between institutions. But requiring reduced leverage create significant costs. Some leverage is good, and there is no optimal across-the-board amount of leverage that is right for every institution.

 
E.     Ensuring Liquidity

Ensuring liquidity could facilitate stability in two ways: by providing liquidity to prevent institutions from defaulting, and by providing liquidity to capital markets as necessary to keep them functioning.

The U.S. Federal Reserve Bank already has the role of providing liquidity to prevent institutions from defaulting, by acting as a lender of last resort. This approach is costly, however. By providing a lifeline to financial institutions, a lender of last resort fosters moral hazard by encouraging these entities—especially those that believe they are “too big to fail”—to be fiscally reckless.¹² It also can shift costs to taxpayers since loans made to institutions will not be repaid if the institutions eventually fail.¹³

The subprime crisis has shown that, in an era of disintermediation, more attention needs to be focused on providing liquidity to capital markets as necessary to keep them functioning.¹⁴ This approach should also be less costly than lending to institutions. A market liquidity provider of last resort, especially if it acts at the outset of a market panic, can profitably invest in securities at a deep discount from the market price and still provide a “floor” to how low the market will drop. Buying at a deep discount will mitigate moral hazard and also make it likely that the market liquidity provider will be repaid.¹⁵

One might ask why, if a market liquidity provider of last resort can invest at a deep discount to stabilize markets and still make money, private investors won’t also do so, thereby eliminating the need for the market liquidity provider. One answer is that individuals at investing firms will not want to jeopardize their reputations (and jobs) by causing their firms to invest at a time when other investors have abandoned the market. Another answer is that private investors usually want to buy and sell securities, not waiting for their maturities, whereas a market liquidity provider of last resort should be able to wait until maturity, if necessary.¹⁶

 
F.     Ad Hoc Approaches

The cost and effectiveness of ad hoc, or purely reactive, regulatory responses to systemic risk are, of course, partly dependent on what those responses turn out to be. Ad hoc approaches do not always work. Sometimes they are too late and the harm has been done or no longer can be prevented, and sometimes there is insufficient time to fashion and implement an optimal solution. 

Nonetheless, the article argues that ad hoc approaches should not be dismissed out of hand. They can help to minimize the difficulties in measuring, and balancing, costs and benefits; and they can reduce moral-hazard cost to the extent an institution cannot know in advance whether, if it faces financial failure, it will be bailed out or fail.

 
G.     Market Discipline

Under a market-discipline approach, the regulator’s job is to ensure that market participants exercise the type of diligence that enables the market to work efficiently. This was the type of approach taken by the United States government under the second Bush administration.

Textbooks claim that perfect markets would never need external regulation, thereby providing support for a market-discipline approach. However actual markets, including financial markets, are not perfect. Furthermore, my article has argued that, even theoretically, a firm can lack sufficient incentive to limit its risk taking in order to reduce the danger of systemic contagion for other firms.

The subprime financial crisis dramatically confirms this argument, that preventing systemic risk through market discipline does not always work. Market discipline may nonetheless be attractive as a supplement to other regulatory approaches.

 
II.
Recommendations and Conclusions

Of the regulatory approaches identified, my article finds that regulation establishing a market liquidity provider of last resort not only should have benefits likely to exceed its costs but also is the approach that would have the best chance of minimizing systemic risk under any number of circumstances. The article recommends that such a market liquidity provider be made operational because market collapses can occur rapidly and without warning.¹⁷

The article’s analysis on cost-benefit balancing is not, and in the absence of empirical evidence cannot be, conclusive. All that can truly be said with confidence, the article claims, is that so long as the cost of a systemic meltdown is much greater than the cost of regulation, then regulation should be justified.

This nonetheless provides a useful way of thinking about the cost-benefit balancing because, as the subprime financial crisis has demonstrated, the cost of a systemic meltdown can be catastrophic. Moreover, the article argues, when regulation deals with health and safety issues—as could arise in the case of systemic risk due to its societal impact—the cost-benefit balancing should go beyond strict econometrics. For example, when addressing the risk of catastrophic events or large, irreversible effects where the actual level of risk is indeterminate, regulators often apply a precautionary principle under which they may decide to regulate an activity notwithstanding lack of decisive evidence of the activity’s harm. This same type of precautionary principle, the article argues, should be considered for regulating systemic risk—and thus for assessing the cost-benefit balancing of creating a market liquidity provider of last resort.

Recent experience in the subprime financial crisis supports establishment of a market liquidity provider of last resort. Providing liquidity to the failing mortgage-backed securities markets would have helped to raise the prices of these securities to levels that more closely reflect their real value, bringing back investor confidence.¹⁸ With confidence, credit markets would have reopened, mortgage money would have once again become available, and home prices would have begun rising.¹⁹

Finally, because financial markets and institutions increasingly cross sovereign borders, the article examines how these regulatory approaches might work in an international context. This examination includes the feasibility of internationally regulating systemic risk, the extent to which a market liquidity provider of last resort or other regulatory solutions are universal or should be different for different countries, and the potential for a regulatory race to the bottom if regulation is done only on a national level.

Acknowledgments:

Copyright © 2009 Georgetown Law Journal.

Steven L. Schwarcz is Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding Director, Duke University Global Capital Markets Center.

Professor Schwarcz’s congressional testimony and his numerous articles on systemic risk and the “subprime” financial crisis are available on his SSRN page at http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=33796.

This Editorial is based on the following full-length Article:  Steven L. Schwarcz, Systemic Risk, 97 GEO. L. J. 193 (2008). Click Here for the Full Article.

Because this topic is no longer purely academic, this Editorial revisits the original article’s theoretical framework from the perspective of the current subprime financial crisis—a crisis resulting from a systemic cascade of failures.

My Article exploring the unconscionability game aims to make three contributions.  To begin with, it can help us understand arbitration law better.  I define arbitration law as the set of rules governing when arbitration agreements are enforceable, as well as the rules allocating decisional authority between courts and arbitrators, federal courts and state courts, and federal law and state law.  In particular, the strategic framework can help us make sense of some otherwise puzzling recent trends in the evolution of allocation rules.  As I will explain, these allocation rules can be understood as tools employed by pro-arbitration courts for indirectly combating what they perceive as overly aggressive use of state-law contract defenses such as unconscionability.

Somewhat more broadly, a second objective of the Article is to increase the visibility of the FAA among those who study federal courts law.  The conflict over the FAA implicates some of the recurring themes in the field, in particular the debates over judicial federalism and parity.  Traditionally, these clashes have been most conspicuous in politically charged domains like habeas corpus and civil rights litigation.²  Certainly these old debates retain vitality there, but today the real frontline may be civil litigation that pits consumers, tort claimants, employees, and other individuals against business interests.  Dissatisfaction in some quarters with how state courts and state law handle these cases has manifested itself through federal legislation such as the Class Action Fairness Act, judicial endorsements of broad readings of federal jurisdiction, Supreme Court review of state courts’ punitive damages awards, and, as we explore here, tensions over the scope of the FAA.  Indeed, the FAA provides a particularly fertile ground for the study of judicial federalism because, as explained further below, it imposes on all courts a federal duty of fidelity to general state contract law, a complex rule of decision that almost invites trouble.

Finally, the Article aims to provide a concrete illustration of certain strategic approaches to judicial decisionmaking.  Increasingly, sophisticated models of judicial behavior are moving beyond claims that judicial ideology and preferences matter.  Those claims may be true, yet doctrine is still relevant.  In fact, doctrine can itself be a strategic tool.  Lower courts can make doctrinal choices that accomplish their policy aims while simultaneously shielding their decisions from review.  In response, higher courts can fashion a new, less pliable doctrine in order to improve monitoring and reduce the opportunity for evasion.  The system is not static but reactive—a game.

With those goals in mind, let us see how the unconscionability game has developed and how it is played.

 
I.
Resistance to the Supreme Court’s Program

The Supreme Court has interpreted the FAA expansively, such that it applies to almost all economic transactions and almost every kind of claim, from common law fraud to employment discrimination.  Its principal provisions apply in both federal and state courts to the exclusion of conflicting state law.³ Regardless of whether the Court’s interpretations were correct, they have served to transform the FAA’s reach.

The Court’s fairly rapid embrace of arbitration was a shock to the legal system, or at least portions of it.  All courts and jurisdictions were suddenly required to enforce predispute arbitration clauses in almost every kind of contract, notwithstanding any state common law or statutory law to the contrary.  But while the Supreme Court can change the law, it cannot necessarily change other courts’ preferences.  Some courts, especially certain state courts, continue to view arbitration with skepticism, most often when it comes to cases involving consumers or employees who have signed nonnegotiated arbitration agreements embedded in standard form contracts.  (Their concerns may or may not be justified, but my aims here are simply explanatory and positive.  I do not here engage with the large literature debating whether arbitration is beneficial for consumers and employees.)

Because Supreme Court doctrine has moved so much faster and further to embrace arbitration than have some other parts of the judicial system, there is a sort of hydraulic pressure in the system that will seek release through whatever channels still exist for invalidating, or at least limiting, arbitration agreements.  The main channel that remains open to courts wary of the increasingly pervasive use of arbitration is the proviso in section 2 of the FAA stating that arbitration agreements must be enforced except “upon such grounds as exist at law or in equity for the revocation of any contract.”⁴  A state or federal court can invalidate an arbitration agreement under generally applicable state contract principles, such as unconscionability, but only if it uses those principles evenhandedly, treating arbitration agreements like any other contract; discrimination against arbitration is prohibited.⁵

Demonstrating the potential of the section 2 proviso, the last several years have witnessed a surprising burst of rulings invalidating arbitration clauses as unconscionable, especially in state courts.⁶  These rulings are surprising because unconscionability is usually regarded as an improbable defense that, despite some venerable precedents that appear in casebooks, rarely succeeds.⁷ These rulings typically do not attack arbitration per se—after all, arbitration is now favored as a matter of federal policy—but rather focus on details of contract formation or particular aspects of an arbitration clause, such as restrictions on relief, disadvantageous arbitral procedures, or bans on class-wide proceedings.  California was in the vanguard in employing unconscionability and related doctrines to invalidate arbitration clauses, but one can now find such cases in many places.

The newfound popularity of unconscionability is in part explainable by the simple fact that it is one of the few tools still available to courts that wish to limit the impact of arbitration.  But there is more to it than that.  Another of unconscionability’s virtues is that it provides at least the opportunity for furtive manipulation.  After all, unconscionability is a slippery doctrine; it is extremely difficult to tell if a decision invalidating an arbitration agreement on unconscionability grounds obeys the FAA’s rule of impartial treatment.  This difficulty creates room for courts to misapply, or perhaps even manipulate, state contract doctrines so as to nullify arbitration agreements while simultaneously insulating their decisions from effective scrutiny.

To express matters in somewhat more formal terms, a court wishing to strike down an arbitration agreement has a choice of various instruments.  The chosen basis for the decision can affect the likelihood of review and reversal by a higher court, even when holding the decision’s bottom line constant.  Lower court judges realize this, and so they can manipulate their grounds of decision both to advance their preferred outcomes and to make review of their decisions more costly.  This is the essence of the “strategic instruments” approach to judicial behavior.⁸

In the FAA/unconscionability context, we can posit two competing “decision instruments” for invalidating arbitration agreements.  The first instrument, which is really a collection of slightly different possible rationales, would be a decision of a broad or categorical nature.  Examples include rulings that arbitration agreements abridge the state constitutional right to jury trial, are per se (or presumptively) unconscionable in certain contexts (such as employment), or are inapplicable to certain types of statutory actions (such as consumer protection claims).  The second instrument would be a more contextual ruling to the effect that the particular arbitration agreement at hand is unconscionable (or is adhesive or contravened the nondrafting party’s reasonable expectations, etc.) and so need not be enforced as a matter of generally applicable state contract law.

Although a decision that holds an arbitration clause unconscionable based on a particularized examination of the contract and the circumstances of its formation will have somewhat less precedential impact than would a categorical rule, it has countervailing advantages.  For one, its fact-intensive character makes it opaque to a reviewing court.  When the reviewing court is a federal court, there is the additional difficulty that scrutinizing the ruling may require intimate knowledge of state law.⁹

Beyond opacity, there is another problem that complicates review, one that springs from the substantive law of the FAA.  Recall that the FAA allows courts to invalidate arbitration agreements on the basis of unconscionability, but only if they use unconscionability evenhandedly rather than discriminating against arbitration.  We are accustomed to seeing federal courts conclude that a state court has erred on some matter of federal law; but suppose a state court quotes the proper federal standards and claims to generate an evenhanded application of unconscionability law that strikes down an arbitration clause.  Rejecting the state court’s holding is tantamount to impugning the state court’s honesty, an act that contravenes the etiquette of judicial federalism.  Thus, review of an unconscionability ruling, particularly one from state court, is expressively difficult in addition to technically difficult.

The fact that unconscionability rulings are relatively insulated from review creates an incentive to use them to evade the FAA’s strictures, but are courts taking advantage of that opportunity?  There is reason to think that some are.  To begin with what we might call circumstantial evidence, there is motive.  As discussed above, some courts are not nearly as enthralled with arbitration as is the Supreme Court.  Whether because they seek to honor state statutes, to follow their constituents’ wishes, or simply because they believe arbitration is bad policy, these courts have cause to oppose it.  Further, some judges have basically admitted that they try to circumvent the FAA, and other judges have accused their colleagues of the same.¹⁰  While opportunity, motive, and anecdote might not add up to a conviction, there is also some more systematic evidence that, while limited in several ways, is highly suggestive.  At least two researchers have found that unconscionability challenges to arbitration agreements succeed at abnormally high rates, and they conclude that the reason is that courts apply unconscionability analysis differently in this context.¹¹

In the end, though, producing empirical proof of discrimination, which is extremely difficult, is almost beside the point.  Pro-arbitration courts will evolve doctrine in response to what they believe they are seeing, so the suspicion of manipulation is enough.  And there are at least reasonable grounds for suspicion.

 
II.
Responsive Strategies

I am certainly not the first person to notice the rise of unconscionability challenges to arbitration agreements.  The new popularity of unconscionability and allied doctrines has been aptly described as an attempt, using one of the few tools remaining, to put the brakes on the pro-arbitration trend and to restore some sort of balance.¹² There is much truth in that view, but I believe it is incomplete.  Any balance or equilibrium may be only temporary, for pro-arbitration courts will respond to the new tools being used to limit arbitration.  Sophisticated resistance to arbitration is just one side of the story—one move, but not the last.

What responsive moves are available to pro-arbitration courts like the United States Supreme Court?  There is, of course, the direct approach.  The Supreme Court could grant one of the many petitions for certiorari charging discrimination against arbitration and deem the decision below a manipulation of state law that violates the FAA.  No doubt the Supreme Court has the power to do so:  Although it ordinarily does not review questions of state law, here federal law mandates a duty of evenhandedness in applying state law.  But that is why review of such cases is so expressively taxing, for it is tantamount to impugning the lower court’s integrity.  Indeed, to a significant degree the target courts themselves control whether the reviewing court can assume the pose of the polite corrector of good-faith error.  A sophisticated state court—one that sets forth the governing law correctly, expresses the appropriate pro-arbitration sentiments, and the like—can make things very uncomfortable.

Admittedly, such an attack on a state court’s integrity would not be completely unprecedented.  Although we treat state courts as supreme and unreviewable on matters of state law, we also understand that a misapplication or distortion of state law can in some cases defeat federal rights.  So the federal courts can in certain cases test the bona fides of a state law ruling.  But this is the exception, the rare exception, and it has tended to occur during periods—such as the civil rights era—when there was much reason to suspect the integrity of certain courts.  Thus, when Chief Justice Rehnquist cited some of those extraordinary cases in his Bush v. Gore concurrence—in which he concluded that the Florida Supreme Court’s interpretation of its state election laws “distorted them beyond what a fair reading required”¹³—Justice Ginsburg pointed out the expressive stakes involved:

THE CHIEF JUSTICE’s casual citation of these cases might lead one to believe they are part of a larger collection of cases in which we said that the Constitution impelled us to train a skeptical eye on a state court’s portrayal of state law. . . . [T]his case involves nothing close to the kind of recalcitrance by a state high court that warrants extraordinary action by this Court.  The Florida Supreme Court . . . surely should not be bracketed with state high courts of the Jim Crow South.¹⁴

Given the historical connotations, one can see that a Supreme Court decision rejecting a state unconscionability holding as a discriminatory manipulation of state law would find itself in a rather remarkable category.  Issuing such a ruling would arguably reveal something about the Court’s values, and it would not be flattering:  namely, that it thinks state discrimination against arbitration merits the same extraordinary response, in terms of judicial federalism, as discrimination in the Jim Crow South.

The technical and expressive difficulty of attacking perceived manipulation of unconscionability head-on may explain why the Supreme Court—never shy about enforcing its pro-arbitration preferences—has been surprisingly hesitant to take such a case, letting dozens of petitions for certiorari go by, despite the pleas of prominent Supreme Court litigators and pro-business amici demanding action.  The direct approach to policing compliance with the FAA is not the only approach, however.  Another course is to develop new rules about the allocation of decisional authority between various courts or between courts and arbitrators.  Here I will describe just one allocation strategy.

Consider the question of who—court or arbitrator—decides certain types of challenges to arbitration agreements.  There have long been rules about this subject, including the so-called “separability doctrine” associated with the Prima Paint case.¹⁵  In that case, one party to a contract dispute claimed that the contract had been formed through fraudulent inducement and thus that the entire contract, including its arbitration clause, was unenforceable.  The Supreme Court decided that the challenge to the contract should be resolved by the arbitrator.  This has come to be known as the separability doctrine because an arbitration clause is regarded as separate from, and not necessarily infected by defects in, the container contract.

For a pro-arbitration court suspecting that judicial manipulation of contract defenses is afoot, one could see why aggressive use of separability and other rules shifting authority to arbitrators would be attractive.  There is no need to question hard-to-scrutinize state-law rulings if one takes away, as a matter of federal law, the authority to issue them in the first place.  The allocation rule is relatively easy to monitor.

There are signs that pro-arbitration courts are following just this strategy.  The Supreme Court has not decided an unconscionability case, but a few of its recent decisions have shifted more decisionmaking authority to arbitrators.  A 2006 case, Buckeye Check Cashing, Inc. v. Cardegna, involved a dispute arising from a payday loan agreement that was allegedly void and even criminally usurious under state law.¹⁶  The Florida high court refused to enforce the arbitration clause in the parties’ contract, concluding that the entire contract was a nullity, but the United States Supreme Court reversed and sent the dispute to arbitration.  The Court concluded that it was of no moment that the contract was deemed, as a matter of state law, void ab initio.  The Court’s decision to send the matter to arbitration is quite strange to many people, inasmuch as the decision finds a valid agreement to arbitrate disputes in a null and criminal contract.  But regardless of what one thinks of the outcome, the important point for our purposes is that the Buckeye rule makes these types of cases easy for a federal court to decide in the sense that they only require the application of the federal rule of separability.  No foray into slippery state-law distinctions between voidness, voidability, and other categories is required, for such distinctions are henceforth irrelevant.

The lower federal courts, which lack the luxury of simply denying certiorari, have been forced to deal with unconscionability more directly.  Although the case law on who decides unconscionability challenges is conflicting and continues to develop, there are signs of a trend toward shifting more authority to arbitrators.  The basic point of such cases is simple but powerful:  It is irrelevant that state law deems some limitation on arbitral relief unconscionable if, as a matter of federal law, the arbitrator is supposed to rule on that argument.  Such doctrinal changes are bizarre in some ways, but they do make sense as a way for pro-arbitration courts to ease monitoring of compliance with federal law.

 
III.
A Role for Congress?

My analysis would not be complete without mentioning the potential role of one other player:  Congress.  Congress has the power to rewrite the rules.  Legislation exempting consumer and employment disputes from arbitration would largely eliminate the tensions that generate the unconscionability game, as there is little opposition today to arbitration between sophisticated commercial parties.  Such legislation has been proposed but, in the face of strong opposition from business interests, has not yet progressed far.¹⁷

It is unclear whether Congress will ever come off the sidelines, but even if it does not do so, it can still exert an influence.  Just as inferior courts shape their behavior with an eye toward the anticipated responses of superior courts, the Supreme Court might shape its behavior with an eye toward the anticipated responses of its superior.  Sophisticated Justices would want to avoid provoking Congress into amending the FAA in a way that would harm the Court’s long-term pro-arbitration program.  Unconscionability might operate as a sort of safety valve that makes arbitration politically sustainable.  It permits courts, on a case by case basis, to respond to the most compelling inequities.  At the same time, the mere risk of an unconscionability challenge may prevent drafters of arbitration clauses from overreaching too much.  A sophisticated Supreme Court would tend to be careful about closing off this safety valve.

 
IV.
Conclusion

I have attempted to explain recent and ongoing developments in FAA case law as the result of a strategic interaction between various players with divergent preferences regarding arbitration.  As the Supreme Court has shut off most means of resisting arbitration, courts skeptical of arbitration have increasingly turned to unconscionability doctrine.  The flexibility of unconscionability analysis creates the potential for courts that disfavor arbitration to manipulate state law to limit the FAA’s reach.  This potential noncompliance then drives further responses by pro-arbitration courts like the Supreme Court, including development of new doctrines and allocation rules that ease monitoring by shifting authority from state courts to federal courts and from courts to arbitrators.

Although I believe that arbitration law is an increasingly important topic—and, in particular, that it provides a fertile field for the study of many of the problems that have long interested federal courts scholars—my aims in the Article go beyond the FAA in particular.  Few people today deny that judges’ policy preferences affect at least some of their decisions, but doctrine is not irrelevant.  Indeed, preferences and doctrine need not be forces that pull in opposite directions.  Some of the most interesting recent work in the political science of the courts attempts to accommodate sophisticated understandings of doctrine, casting it as not merely a potential constraint on preferences but also a tool for implementing them.  I have hoped to provide a concrete illustration and contextualized elaboration of such a model of judicial behavior, in which emerging doctrinal changes do not reflect only legal considerations, nor just preferences, but rather respond to the ongoing problem of monitoring lower courts.  Further work at this intersection of legal and political analysis should prove fruitful.

Acknowledgments:

Copyright © 2009 New York University Law Review.

Aaron-Andrew P. Bruhl is Assistant Professor, University of Houston Law Center.

This Editorial is based on the following full-length Article:  Aaron-Andrew P. Bruhl, The Unconscionability Game: Strategic Judging and the Evolution of Federal Arbitration Law, 83 N.Y.U. L. REV. 1420 (2008).
Click Here for the Full Article