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Abstract:
The study argues that commercial banks pose unique corporate governance problems for managers and regulators, as well as for claimants on the banks' cash flows, such as investors and depositors. The authors support the general principle that fiduciary duties should be owed exclusively to shareholders. However, in the special case of banks, they contend that the scope of the fiduciary duties and obligations of officers and directors should be broadened to include creditors. In particular, the authors call on bank directors to take solvency risk explicitly and systematically into account when making decisions or else face personal liability for failure to do so.

corporate governance, commercial banks, fiduciary duties

Abstract:
Enron and other corporate financial scandals focused attention on the accounting industry in general and on Arthur Andersen in particular. Part of the policy response to Enron, the criminal prosecution of Andersen, eliminated one of the few major audit firms capable of auditing many large, public corporations. This article explores whether Andersen's performance, as measured by frequency of financial restatements, measurably differed from that of other large auditors. Financial restatements trigger significant negative market reactions and their frequency can be viewed as a measure of accounting performance. We analyze the financial restatement activity of approximately 1,000 large, public firms from 1997 through 2001. After controlling for client size, region, time, and industry, we find no evidence that Andersen's performance significantly differed from that of other large accounting firms.

Abstract:
Since 1995 more than 7300 firms have delisted from U.S. stock markets, with almost half of these being involuntary. This paper examines the law and finance of the delisting process. We examine economic rationales for delisting, the legal rules that define it, and the causes of delisting. Using a sample of NYSE firms delisted in 2002, we examine the effects of their delisting and subsequent trading on the Pink Sheets. We find huge costs to delisting, with percentage spreads tripling, volatility doubling, but volume remarkably high. We also show that delisting is applied inconsistently, with some firms trading for months after failing the listing requirements. We argue that the current delisting process is flawed, and we provide some alternatives.

Abstract:
Countries appear to differ considerably in the basic orientations of their corporate governance structures. We postulate the trade-off between objectivity and proximity as fundamental to the corporate governance debate. We stress the value of objectivity that comes with distance (e.g. the market oriented U.S. system), and the value of better information that comes with proximity (e.g. the more intrusive Continental European model). Our key result is that the optimal distance between management and monitor (board or shareholders) has a bang-bang solution: either one should capitalize on the better information that comes with proximity or one should seek to benefit optimally from the objectivity that comes with distance. We show that this result points at an important link between the optimal corporate governance arrangement and industry structure. In this context, we also discuss the ways in which investors have "contracted around" the flaws in their own corporate governance systems, pointing at the adaptability of different arrangements.

Abstract:
In this Article, we argue the internal corporate governance structure of the big accounting firm is fundamentally flawed, and that this flaw contributed to the current crisis of confidence in the integrity of public reporting. The incentive structure within accounting firms makes it virtually impossible for auditors to be independent of significant clients like Enron. The result has been a change in the balance of economic power between accounting firms and their clients - individual audit partners suffer from client capture. In addition, to their lack of independence, accounting firms and partners lack accountability in part due to the advent of the limited liability partnership structure. Despite these problems, federal securities laws and regulations require auditors to provide independent audits to companies. The result has been the commodification of audits and a market in which audits are bought and sold. As a consequence, audits no longer serve the economic purpose for which they were required - providing information that protects investors and leads to the efficient pricing of securities.

Although the provisions of the Sarbanes-Oxley Act offer some help in resolving the capture, governance, and commodification concerns we raise, we conclude that more is needed. Sarbanes-Oxley established the Public Company Accounting Oversight Board. This Board is to register the public accounting firms, set standards for their reports, inspect and investigate the firms, and, when appropriate, sanction firms and individuals. To be successful, the Board will have to replace the incentive system eliminated with the creation of LLPs with its own set of rules and standards, which it will have to enforce vigorously. In addition, Sarbanes-Oxley provides new standards for auditor independence, establishing a requirement that audit firms rotate the partners assigned to clients in order to prevent capture. We conclude that this provision is less likely to achieve its goal, as long as client satisfaction remains the dominant measure of partner performance. Instead, we argue that until lead audit partners are confident that they can fire dishonest clients without fear that doing so will result in the destruction of their own careers, the problems that contributed to the Enron and other significant corporate failures will continue to exist.

Enron, Corporate Governance, Securities Law, Securities Regulation, Corporate Law, Sarbanes-Oxley

Abstract:
Much of the blame for the current financial crisis is attributable to problems in the subprime mortgage market. In this Article we argue that changes in the nature of the mortgage contract make it both legally plausible and normatively desirable that subprime mortgages brokers be treated as securities broker-dealers for the purposes of the Securities Act of 1933 and the Securities and Exchange Act of 1934. Modern subprime mortgages are, in large part, investments that contain imbedded options, and are not subject to any alternative comprehensive regulatory regime. Thus, they should qualify as "notes" under the Securities Act definition and the Supreme Court's Reves test, and expose their brokers to Rule 10b-5 oversight. In the alternative, we argue that the emergence of securitization as the primary process by which mortgages are financed provides a second, independent analytical basis for our theory that subprime mortgage financings should be subject to securities law: Mortgage financings qualify for the protections of rules such as SEC Rule 10b-5 because they occur "in connection with the purchase or sale of a security," namely, the mortgage-backed security that is created and funded on the basis of the cash flows from the mortgagors' payments on their subprime mortgages.

Were the SEC to take control of subprime mortgages brokers, rules that forbid the sale of financial instruments to any person unless investing in those instruments is appropriate (suitable) to the investment needs and risk tolerance of that investor would come into play, oversight that would have avoided or greatly mitigated the current crisis. In describing what suitability would do for the mortgage market, we make a novel distinction between "product" and "transaction form" suitability in our analysis of the suitability rules. We argue that transaction form suitability is the appropriate legal theory to use when pursuing people who have unscrupulously sold subprime mortgages to unsophisticated investors. In closing, we discuss reasons why we believe the SEC has not tried to exert this authority to date, and address the likely result of a legal challenge in the event the SEC were to adopt our proposal by rule.

securities law, subprime, reves test, crisis, mortgage

Abstract:
In this paper we identify the tradeoffs between objectivity and proximity as fundamental to the corporate governance debate. We stress the value of objectivity that comes with distance (e.g., the market-oriented U.S. system), and the value of better information that comes with proximity (e.g., the more intrusive Continental European model). Our key result is that the optimal arrangement between management and monitor (board or shareholders) should either capitalize on the better information that comes with proximity or seek to optimally exploit the objectivity that comes with distance. We argue that the asset structure, in particular, the irreversibility of investments, and the opportunity costs associated with resource misallocation critically determine the optimality of the distance- or proximity-based arrangement. We also discuss the ways in which investors have contracted around the flaws in their own corporate governance systems, pointing at the adaptibility of different arrangements.

Corporate governance, monitoring, asset structure

Abstract:
Among the clearest rules in U.S. securities law is the duty that brokers have to "seek the best execution that is reasonably available for its customers' orders." The problem with the current orientation of the policy discussion on best execution is that it has focused on the narrow, yet unanswerable, question of which venue provides traders with "best execution." For example, it makes no sense to employ the same, or even a similar, legal definition of the duty of best execution for large institutional traders and for small retail traders. In this article, we examine the alternative institutions most likely to generate optimal rules regarding best execution.

Brokers, best execution, traders, securities law

Abstract:
This article proposes a simple and coherent approach to judicial review of class action settlements. Specifically, we propose that for questions going to the adequacy of a settlement, where no warning signals of fraud or collusion are found, the court should act relatively deferentially by employing a lenient standard of scrutiny and approving a settlement if it has a rational basis. An intermediate level of scrutiny should apply when the settlement presents facial issues that implicate the fairness of the settlement. Such facial issues include the allocation of settlement proceeds among subgroups in a class, the presence of coupon-type relief, "shotgun" settlements occurring very early in the litigation, and settlements in overlapping class actions. In settlements with one or more of these characteristics, if the initial inquiry raises concerns, the court should demand a well-reasoned explanation for the choices made. Finally, where the components of a settlement present a direct conflict between the interests of class counsel and those of the class issues, such as issues related to attorneys' fees, courts should employ exacting scrutiny and require convincing evidence that the proposal is reasonable.

judicial review, class action settlements

Abstract:
This article proposes a simple approach to judicial review of class action settlements. The key is to recognize that courts should apply different degrees of scrutiny for different issues depending on the respective competence of the court and class counsel. For questions going to the adequacy of the settlement, where no warning signals of fraud, collusion or inadequate bargaining leverage are found, the court should employ lenient scrutiny and approve the settlement if it has a rational basis. An intermediate level of scrutiny should apply to issues implicating the fairness of the settlement, including the allocation of settlement proceeds among subgroups in the class, the presence of coupon-type relief, "shotgun" settlements occurring very early in the litigation, and settlements in overlapping class actions. Here, if the initial inquiry raises concerns, the court should demand a well-reasoned explanation for the choices made. For the issue of attorneys' fees and other questions presenting a direct conflict between the interests of class counsel and those of the class, courts should employ exacting scrutiny and require convincing evidence that the proposal is reasonable.

Abstract:
This Article analogizes the state, in its role as tax collector, to that of an investor, or to be more precise, that of a residual claimant on the earnings of all of the people and firms subject to the taxing power of the state. The relationship between modern democracy and its citizens would be strengthened if this analogy were more widely acknowledged because it recognizes citizen-taxpayers as contracting partners with the state. Unlike other libertarian conceptions of the state's taxing authority, the framework developed here does not jeopardize the state's ability to collect the revenues it needs to provide for the protections of its citizens.

The state-as-investor framework developed in this Article leads to a number of tax policy improvements. The framework suggests limits on the government's ability to change people's tax status after they have already embarked on careers and made the sunken, non-diversifiable investments in human capital that such career training requires. The framework advanced here also suggests that people should be able to make a once-in-a-lifetime payment in lieu of taxes to the state in order to discharge their tax liability. This approach articulated here also seems superior to the utopian suggestion offered by Ayn Rand that taxation be voluntary, as well as to the unrealistic suggestion made by Nozick that income taxes are violative of man's natural rights.

Tax Policy, Finance, law and economics

Abstract:
This article presents a critical economic analysis of the European Union's legal capital rules as codified by the Second Directive. Professors Enriques and Macey explore the fundamental differences between United States and European Union approaches to the conflict between fixed and equity claimants and argue that the European Union should abandon its inefficient approach. The costs associated with the European legal capital rules - particularly costs to shareholders, creditors, and society as a whole - significantly outweigh any benefits accrued by creditors. The authors suggest that a public-choice theory best explains the existence of the European legal capital rules, in that certain influential interest groups benefit from the rules despite their inefficiency. In conclusion, this Article advocates that the European Union should abandon its current legal capital rules in favor of more flexible, contractarian rules in order to facilitate entrepreneurship and business development in European markets.

Abstract:
This Article explains the economic nature of the services that banks provide. On the liability side of the balance sheet, banks' demand deposit accounts are shown to offer depositors a form of liquidity insurance. Rival providers of liquidity, such as money market mutual funds, offer services that are economically distinct from the transactions services offered by banks. These rival services are not perfect substitutes for the services that banks provide. Similarly, on the asset side of banks' balance sheets, banks specialize in offering close, finely textured monitoring to borrowers. This monitoring service not only is of value to firms and individuals that do not have access to public debt markets, but also to all firms that face moral hazard when borrowing. Bank lending provides credible assurances to other investors that the borrower will receive continuous monitoring. Thus, bank lending lowers borrowers' overall capital costs. This analysis shows that banks serve a distinct and important economic role and challenges the commonly held view that commercial banking is a declining industry whose core functions are being supplanted by securitization and other technological and financial innovations. The recent reforms of the financial services industry are examined within this analytical framework. The Article disputes the popular view that Gramm-Leach-Bliley was necessary in order to permit banking organizations to reduce their dependence on traditional commercial banking activities that are becoming obsolete. The Article argues that a more plausible explanation for Gramm-Leach-Bliley is that the statute was passed because it served the interest of large financial conglomerates, particularly investment banks, who wanted to enter the profitable field of commercial banking.

Abstract:
Ever since publication of Berle and Means' 1932 classic, "The Modern Corporation and Private Property," many have believed that there are significant problems with the American system of corporate governance. In particular, the separation of ownership and control identified with the American publicly held corporation is said to produce an organizational structure in which shareholders face collective action problems that make it impossible for them effectively to monitor and discipline the management of the firms in which they have invested. Professional managers are said to be virtually unaccountable to shareholders.

Recently scholars have suggested that institutional investors are the group most likely to resolve America's corporate governance problem. Other commentators, however, have questioned the merits of having institutional investors take a more active role in corporate governance. Roberta Romano, for example, has shown that public pension funds face political constraints that are likely to prevent them from serving very effectively as monitors of corporate mangers. As for corporate pension funds and financial institutions, it has long been recognized that these institutions face conflicts of interest that prevent them from serving as effective representatives of the interest of outside shareholders. Jack Coffee has pointed out that the kind of long-term, "relational" investing required to make institutional investors a voice in corporate governance may be too costly to such investors because it will require them to sacrifice liquidity. Jill Fisch has argues that institutional investors may not find it rational to engage in relational investing unless they are given special benefits such as special information about control.

Abstract:
Corporate law allocates to the board of directors the central role in the management of the American corporation. However, many boards meet only episodically, and are mostly comprised of outsiders nominated and influenced in various ways by the managers they are supposed to monitor. In this article we argue that shareholders should be able to contract around the necessity for board oversight of managerial decisionmaking. In particular, we propose that corporate law be clarified to allow shareholders (1) to give management a vote of "no confidence" at the annual meeting which would require boards to initiate a search in order to replace incumbent management; and (2) to allow shareholders to put up for sale the firms in which they own stock without the necessity of obtaining the prior approval of the board. We recognize that in a variety of situations, board involvement can enhance shareholder value. This is particularly true in the takeover context, where boards of directors can engage in a variety of tactics to ensure that shareholder value is enhanced. At the same time, we strongly favor an expanded approach to shareholder choice in corporate law. We advocate expanding the standard set of corporate charter provisions to permit shareholders to customize their corporate charters so as to permit shareholders to oust management or to sell their firm.

Abstract:
In this article we maintain that corporate governance systems can be evaluated by the degree to which they accomplish three objectives: (1) lowering contracting costs by providing default rules and reliable enforcement of such rules; (2) lower agency costs by providing mechanisms for controlling managers; and (3) protect specific human capital investment. Differences in corporate governance systems reflect the fact that different systems accomplish these three objectives in different ways. Differences in corporate governance systems also reflect the fact that different societies impost different cultural and legal constraints on the ways that firms are financed and governed.

Different corporate governance systems also reflect local adaptations to local legal and cultural constraints on financial contracting. In other words, differences in corporate governance systems reflect the different ways that investors have "contracted around" restrictions in their own legal and social orders in order to make the most efficient investments possible under a given set of constraints.

These insights have implications for regulatory reform. In particular, we argue that making improvements in one aspect of a corporate governance system, in order, for example, to improve the way that a corporate governance system reduces agency costs, can weaken that system in other ways, for example by reducing the ability of the system to protect human capital investments.

Despite the rich differences among various systems of corporate governance, two basic paradigms of corporate governance, the U.S. paradigm and the German paradigm, dominate the literature. The U.S. paradigm is that of strong capital markets but weak institutional constraints on management. The German paradigm is of strong institutional (bank) controls on management to compensate for weak capital markets. In addition to the trade-off in corporate governance between the characteristic of liquidity, which provides investors with a ready *exit option,* and the characteristic of *voice,* policymakers face another, related tradeoff when designing a corporate governance system. This is the tradeoff between objectivity and proximity. In systems such as those that exist in Germany, the Netherlands and elsewhere, there is finely textured monitoring by sophisticated, institutional investors. However, in these systems, the monitors often do not respond to the signals they are receiving because they have become *captured* by the firms they are monitoring. This happens because the monitors have become co-opted into adopting the perspective of the firms they are ostensibly monitoring. Thus the informational advantage enjoyed by the insiders in certain corporate governance systems is mitigated by the fact that these investors may lack the ability to evaluate the performance of the firms they are monitoring in an objective manner.

By contrast, in a corporate governance system like the one that exists in the U.S., where there is considerable distance between investors and management, investors face an obvious problem in obtaining detailed, reliable information about the firms in which they are investing, since management will have incentives to withhold information or to provide inaccurate information. Even where there is disclosure, rational ignorance and free-riding prevent investors from benefitting from the information they receive. On the other hand, the distance that U.S. investors have from the firms in which they are investing brings with it a degree of objectivity lacking in corporate governance systems in which investors enjoy large degrees of control.

We argue that this tradeoff between objectivity and control is systemic and intractable. As a result, corporate governance systems that take steps to improve one vector of corporate governance performance, for example by improving the quality of capital markets in order to reduce contracting costs or agency costs, will weaken other aspects of their system, for example by weakening protections for investments in human capital.

Abstract:
The vitality of the takeover market is approaching a critical juncture. Certain management teams and their lawyers and lobbyists have convinced a passel of state legislatures and state judges to try to kill the market for corporate control.

With the rise of the poison pill and the just-say-no defense, things have not looked so bleak for takeovers since the collapse of Drexel Burnham in the 1980s killed the junk bond market and, with it, the ability to finance major league acquisitions. Delaware courts, for example, have validated the poison pill and seem to be reluctant to restrain its use even in the most egregious circumstances.

Nevertheless, takeovers have made a modest comeback in the early 1990s. And, just as lawyers almost killed the takeover market with the inversion of the poison pill [in the '80s], now they are about to reinvigorate it with another legal invention. The invention is the "shareholder rights by-law," and it promises to be the next major legal battleground in the market for corporate control.

The advantage currently enjoyed by incumbent management in the takeover wars comes from legal toleration of the poison pill. Poison pills can protect shareholders in some cases, but too often target management uses the pill to thwart outside bids even when target firm shareholders want to sell out. Poison pills discourage takeovers by giving target shareholders the right to purchase hundreds of millions of dollars' worth of additional shares at firesale prices when there is a takeover attempt. The pills stay in place until target company directors agree to nullify or "rescind" them.

Poison pills were originally intended to slow down takeovers, thereby allowing the board of directors to fully evaluate a bid, seek other bidder, or negotiate superior term for the shareholders. In other words, the pill was originally intended to act as a means for allowing the board to fulfill its responsibility of maximizing value for the shareholders. It was not "seen as a means for entrenched management teams to thwart takeovers."

Abstract:
This paper reviews and analyzes the legal and economic aspects of the duty of best execution. Although a well-established principle of securities trading, we show that the dual problems of definition and enforcement make best execution both unwieldy and unworkable as a mandated legal duty. We examine the impact of several market practices on best execution, in particular payment for order flow, preferencing and internalization practices, and price improvement and order execution protocols. We suggest three possible directions for the future rule and interpretation of the duty of best execution.

Abstract:
This paper models the ethical rules applicable to attorney conflicts of interest as default terms for the attorney-client relationship which the legal system supplies in the absence of complete contracting by the parties. Following an approach which is standard in the literature, we model the attorney-client relationship as an agency relationship characterized by large information and monitoring difficulties. We conclude that, in general, a regime of granting the client the right to bar subsequent, conflicting representation of other parties by the attorney, subject to ex post renegotiation by the attorney and client, represents an optimal approach to the problem. Economic theory predicts, however, that there should be a threshold of harm to the client, below which the attorney should be allowed to represent another party without obtaining the first client's consent. In general, the ABA Model Code of Professional Responsibility and Model Rules of Professional Conduct adopt a regime of conflicts regulation that is quite consistent with economic theory. We suggest that the bar has an incentive to adopt efficient rules in this area because its interests are closely aligned with the public's: both have an interest in facilitating efficient contracting between attorney and client -- the bar, to increase profits; the public, to reduce costs.