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Abstract: This article addresses the implications that the Enron collapse holds out for the self regulatory system of corporate governance. The case shows that the incentive structure that motivates actors in the system generates much less powerful checks against abuse than many observers have believed. Even as academics have proclaimed rising governance standards, some standards have declined, particularly those addressed to the numerology of shareholder value. The article's inquiry begins with Enron's business plan. The article asserts that there may be more to Enron's "virtual firm" strategy than meets the eye beholding a firm in collapse. The article restates the strategy as an application of the incomplete contracts theory of the firm that prevails in microeconomics today and asserts that Enron failed because its pursuit of immediate shareholder value caused it to misapply the economics, mistaking its own inflated stock market capitalization for fundamental value. The article proceeds to Enron's collapse, telling four causation stories. This ex ante description draws on information available to the actors who forced Enron into bankruptcy in December 2001. The discussion accounts for the behavior of Enron's principals by reference to the shareholder value norm and Enron's corporate culture. Finally, the article takes up the self regulatory system of corporate governance, asserting that the case justifies no fundamental reform. The costs of any significant new regulation can outweigh the compliance yield, particularly in a system committed to open a wide field for entrepreneurial risk taking. If we seek high returns, we must discount for the risk that rationality and reputation will sometimes prove inadequate as constraints. At the same time, we should hold critical gatekeepers, particularly auditors, to high professional standards. The article argues that present reform discussions respecting the audit function do not adequately confront the problem of capture demonstrated in this case.
Abstract: This paper takes up the main questions addressed by the literature on comparative corporate governance: Whether national governance systems can be expected to converge in the near future, and whether the focal point of that convergence will be a new, hybrid governance system comprised of best practices drawn from different systems. The paper advances the view that neither global convergence that eliminates systemic differences nor the emergence of a hybrid best practice safely can be projected because each national governance system, rather than consisting of a loose collection of separable components, is tied together by a complex incentive structure. Interdependencies between each system's components and the incentives of its actors create significant barriers to cross reference to and from other systems. In contrast, the cross-reference hypothesis widely advanced in the comparative governance literature presupposes divisible institutions?a world in which one system's components can be adapted for use in the other system without significant frictions or perverse effects. The paper draws on models of monitoring and blockholding articulated in the incomplete contracts theory of the firm. Under incomplete contracts theory, different governance systems have incentive structures that entail different trade offs?trade offs between ownership concentration and liquidity, between monitoring and management initiative, and between private rent seeking and activity benefitting shareholders as a group. The trade offs delimit opportunities for productive cross reference. More particularly, blockholder systems, such as those in Europe, subsidize monitoring by permitting blockholders to reap private benefits through self dealing and insider trading. Market systems, such as those in the United States and Britain, regulate such private rent seeking toward the end of maintaining an institutional framework that supports diffuse share ownership and liquid trading markets. It follows that a legal framework conducive to blockholding may be ill equipped to foster dispersed equity ownership and thick trading markets, and that a legal framework conducive to liquid trading markets may have properties that discourage blockholding. There result questions for law reform agendas on both sides of the Atlantic. In the United States proponents ask for deregulation of controls on institutional investors, looking to encourage blockholding and more effective monitoring. In Europe proponents ask for stronger securities regulation, looking to encourage deeper trading markets. The paper projects that each reform program may lead to disappointing results because neither assures conforming adjustments to the pertinent actors' incentives. Alternatively, strict reforms that materially change prevailing incentive patterns could perversely destabilize workable (if imperfect) arrangements without assuring the appearance of more effective alternatives.
Abstract: Adolf Berle and Gardiner Means' The Modern Corporation and Private Property still speaks in an active voice. Since it first appeared in 1932, corporate law has been reckoning with its description of a problem of management responsibility stemming from the separation of ownership and control. Today, Berle and Means remain at the forefront of policy discussion in a field where even a highly successful academic contribution rarely has a shelf life exceeding ten years. This essay seeks to explain the longevity of Berle and Means' book by looking at the book in the context of its time, comparing the contemporary contributions of other authors on the theory of the firm and corporate reorganization. It then goes on to reconsider the book in the context of contemporary corporate legal theory by first looking at the book as an early example of corporate law and economics. The essay then examines how Berle and Means' description of the problem of separation of ownership and control synchronizes with contemporary views on corporate governance. Finally, the essay turns to the solution the book recommends for the problem of separated ownership and control, a judicially-enforced norm of trust. The essay concludes by noting that while Berle and Means' trust model was never adopted in corporate law or corporate legal theory, shareholder value maximization is more embedded than ever as the field's governing norm. The essay notes that the trust model has played a critical role in the shaping of corporate fiduciary law. Although Berle and Means' prescription for remedying the problem of separation of ownership and control is considered a policy relic, the importance of their book continues because it identified and discussed problems left untreated then and later. Leading corporate governance discussions still implicate the separation of ownership and control because, as Berle and Means asserted, the separation implies shortfalls of competence and responsibility.
Abstract: This paper reconsiders Berle and Means' The Modern Corporation and Private Property in the context of contemporary corporate legal theory. Although the book lost its paradigmatic status in the field two decades ago, it retains an enviable place at the forefront of policy discussions. The paper seeks to explain this unusual longevity, in a three-part discussion. The first part places the book in the context of the legal theory of its day by comparing work of John Dewey on the theory of the firm and William O. Douglas on corporate reorganization. This discussion highlights two progressive assumptions Berle and Means shared with these business law contemporaries?a confidence in the efficacy of judicial intervention to vindicate distributive policies and a distrust of the institution of contract. The second part takes up Berle and Means' description of the separation of ownership and control. It is here that Berle and Means still speak in an active voice. The split in the classical entrepreneurial function has come to be seen as a problem by observers on all points of twentieth century America's ideological spectrum, even as few have denied the large corporation's success as a producer. The problem has never been solved, despite strenuous efforts to assert the contrary in first-generation law and economics. Instead of clear cut solution of the problem, we instead have seen a process of accommodation and adjustment between the management-controlled corporation and the wider economy and society. The process, which began before the turn of the twentieth century, continues into the twenty first. More particularly, Berle and Means' description of the problem synchronizes neatly with contemporary views on corporate governance. It turns out that even the latest microeconomic theory of the firm in the incomplete contracts framework coexists in consonance with the book. The third part reconsiders the solution Berle and Means recommended for the problem of separated ownership and control, a judicially-enforced norm of trust. This has been eclipsed in business law. Even so, The Modern Corporation and Private Property hedges its prescriptive presentation carefully enough to retain a measure of plausibility in a contemporary reader's eyes. More importantly, the book's prescriptive miss follows less from the its analysis of corporate problems than from now-discarded progressive assumptions about regulation and contract. Finally, the book's failure accurately to predict the future course of corporate fiduciary law stems in part from a development Berle could not reasonably have been expected to anticipate--the rise of the Delaware courts to a dominant place in the making of corporate case law due to the ancillary disappearance of federal common law after Erie Railroad Co. v. Tompkins.
Abstract: Corporate governance interventions by hedge fund shareholders are triggering debates between advocates of management empowerment and advocates of aggressive monitoring by actors in the capital markets. This Article intervenes with an empirical question: What, based on the record so far, have the hedge funds actually done to their targets? Information has been collected on 130 domestic firms identified in the business press since 2002 as targets of activist hedge funds, including the funds' demands, their tactics, and the results of their interventions for the targets' governance and finance. The survey results show that the hedge funds have an enviable record success in getting targets to accede to their demands, using the proxy system with remarkable, perhaps unprecedented, success. If the pattern of intervention persists in time, expands its reach, and maintains the present high level of governance success, then the separation of ownership and control becomes a less acute problem for corporate law. But such a change will occur only to the extent that clear cut financial incentives encourage an expanded field of intervention. To get a sense of the sample's bearing on the question as to such incentives' existence, returns from hedge fund engagement with the sample firms are compared to returns from market indices. The results are mixed. The answer to the question whether the activists have beaten the market depends on the assumptions one brings to the comparison. But it at least can be argued that the hedge funds have not beaten the market respecting the targets in the sample. A question accordingly arises respecting the depth and durability of any shift in the balance of corporate power stemming from hedge fund activism. Meanwhile, the financial results also show that hedge fund activism is a more benign phenomenon than its critics would have us believe. Hedge fund interventions neither amount to near-term hold ups nor revive the 1980s leveraged restructuring. Short term investments are rare. Large cash payouts have been made by only a minority of the firms surveyed, and borrowing has been the mode of finance in only a small minority of the payout cases.
corporate governance, corporations, dividends, hedge funds, proxy voting, shareholder activism, securities regulation
Abstract: In our self-regulatory system of corporate law, the job of insisting on trustworthy numbers devolves in the first instance on the gatekeepers. It follows that the auditors take the brunt of the blame and that the Sarbanes-Oxley Act (the "Act"), the legislation intended to address the scandals and restore confidence in the securities markets, responds by regulating the accounting profession. More accurately, Sarbanes-Oxley triggers the start of a political process intended over time to produce a new regulatory regime. The statute follows the standard regulatory strategy of delegating most of the task of devising the new regime's terms to an administrative agency, a new Public Oversight Board (POB). The regulatory outcome remains open accordingly. High financial stakes imply an ongoing political contest over the POB's political and institutional gestalt and the terms of any new regulation. The resulting uncertainty, although regrettable, probably could not have been avoided. Unfortunately, Sarbanes-Oxley does not stop with an open-ended delegation of authority respecting the audit function to a new agency. The Act goes on to address the substance of Generally Accepted Accounting Principles (GAAP). It does this first in section 108(d), which requires the SEC to study the accounting system to ascertain the extent to which it is "principles-based," as opposed to "rules-based," and to tell us how long it will take for us to achieve a "principles-based" system; and second, in section 108(a), which requires the Financial Accounting Standards Board (FASB) and any other approved standards-setting body to adopt procedures ensuring prompt consideration of new rules reflecting "international convergence on high quality accounting standards." Given an ongoing political contest respecting the shape of the POB and its regulatory program, critical questions need to be asked about these substantive initiatives. More particularly, this Article asks whether substantive intervention into the articulation of GAAP could trigger just the sort of regulatory error that the agency delegation model, followed in respect of the POB, was intended to avoid. "Principles-based accounting" and "international convergence," however desirable in the abstract, have to be considered in light of the institutional contexts in which they would operate and effect consequences. "Principles" and "convergence," by themselves do little to constrain rent-seeking behavior on the part of managers and auditors. Absent antecedent institutional reform that ensures auditor independence and lessens the negative impact of rent-seeking and influence activity on audit quality, perverse effects could follow in the event that sections 108(d) and 108(a) influence GAAP's future shape. Unfortunately, Sarbanes-Oxley does not ensure the requisite institutional reform; it merely holds out the possibility of reform. Part I describes Sarbanes-Oxley's delegation to the POB, surveying the issues the Act leaves open and the ongoing political contest respecting their resolution. Part II situates the principles-based accounting that the Act commends in the context of the Enron disaster. This discussion begins with a story currently in circulation - that Enron exemplifies the abuses of rules-based accounting under GAAP and demonstrates the need to move to principles-based accounting. The discussion then falsifies the story, showing that Enron violated both rules and standards under GAAP. Full responsibility for the disaster goes to the enforcement of GAAP's rules and standards by Enron's auditor rather than to the rules and standards themselves. The discussion then broadens, explaining why the relative merits of rules and principles are being debated in respect of GAAP at this time, and how the principles-based argument rests on a false premise, holding out risks for audit quality.
Enron, Corporate Governance, Securities Law, Corporate Law, Sarbanes-Oxley
Abstract: The Sarbanes-Oxley Act follows the standard regulatory strategy of delegating the most of the task of devising a new regulatory regime's terms to an administrative agency, in this case the accounting profession's new Public Oversight Board (POB). In so doing it less establishes a new regulatory regime than it triggers the start of a political process intended over time to produce the new regime. The regulatory outcome remains open accordingly. High financial stakes imply an ongoing political contest over the POB's political and institutional form and the terms of any new regulation. Sarbanes-Oxley goes on to address the substance of Generally Accepted Accounting Principles (GAAP). It does this first, in section 108(d), which requires the SEC to study the accounting system to ascertain the extent to which it is "principles based" as opposed to "rules based" and to tell us how long it will take to us to achieve a "principles based" system; and, second in section 108(a), which requires Financial Accounting Standards Board (FASB) and any other approved standards-setting body to adopt procedures assuring prompt consideration of new rules reflecting "international convergence on high quality accounting standards." Given an ongoing political contest respecting the shape of the POB and its regulatory program, critical questions need to be asked about these substantive initiatives. More particularly, this Article asks whether substantive intervention into the articulation of GAAP could trigger just the sort of regulatory error that the agency delegation model, followed in respect of the POB, was invented to avoid. "Principles based accounting" and "international convergence," however desirable in the abstract, have to be considered in light of the institutional contexts in which they would operate. "Principles" and "convergence," by themselves do little to constrain rent-seeking behavior on the part of managers and auditors. Absent antecedent institutional reform that assures auditor independence and lessens the negative impact of rent-seeking and influence activity on audit quality, perverse effects could follow in the event that sections 108(d) and 108(a) influence GAAP's future shape. Unfortunately, Sarbanes Oxley does not assure the requisite institutional reform; it instead merely holds out the possibility of reform.
Abstract: The dividend puzzle of economic theory asks why firms pay substantial dividends, given the classical tax rate preference for capital gains and deferral of capital gains taxation until realization. A new dividend puzzle arises at the level of practice in the wake of The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the JGTRRA), which aligns tax rates on shareholder capital gains and dividend income at a maximum 15 percent even as it leaves in place the capital gains deferral. The new tax regime puts a difficult question to corporate boards: Whether, assuming payout, dividends hold out relative advantages over stock repurchases as the mode of payment. Prior to rate parity, a sequence of justifications supported a growing preference for open market stock repurchases (OMRs) over dividends: (1) OMRs held out the capital gains rate shift for the selling shareholders, along with a tax deferral and rate shift for nonselling shareholders. (2) OMRs signaled good news and supported the firm's stock price in the market. (3) Because OMRs suited management's preferences, they facilitated payout and reduced the risk of suboptimal earnings retention. (4) OMRs increased earnings per share by reducing the number of shares outstanding. (5) Managers executing OMR programs could take advantage of information asymmetries to execute repurchases at bargain prices. Old fashioned dividends, in contrast, carried a tax disadvantage for most shareholders, did nothing for earnings per share, did less than OMRs to support the stock price, and overly constrained cash flow management. Rate parity under the JGTRRA removes the first of the five justifications in substantial part. Indeed, tax considerations influenced payout practice only marginally even given a rate differential. The shift in the tax regime invites reconsideration of the weight to be accorded justifications (2) through (5). As to (2), the Article shows that signaling value is too weak to explain or justify the shift to repurchases. As to (3) and (4), management flexibility and earnings per share enhancement, the Article makes a three-part response. First, the shift to repurchases diminishes the disciplinary benefits of dividends, complicating any justificatory resort to agency theory. Secondly, the shift to repurchases proceeded in tandem with the 1990s shift to stock option compensation, as firms repurchased stock to offset the dilutive effect of option exercises on earnings per share. An OMR program's value to long term holders accordingly depends on the option plan's success as incentive compensation. Thirdly, dividends do not have to be sticky. Sporadic free cash flows can be distributed as dividends without triggering unjustified market expectations if management draws on the practice of a half century ago and declares a special dividend. As to (5), bargain repurchases, there are two countervailing factors. First, any bargain repurchase possibility depends on the framework of market regulation. The securities laws allow firms to time repurchases in secret, letting them take advantage of market volatility. In a regime of imposed transparency, the bargains for the most part would disappear. Secondly, management can be wrong in viewing its stock as undervalued. To the extent that an OMR program sweeps up overvalued stock, it benefits selling shareholders to the detriment of long-term holders who suffer dilution. This possibility mattered little under the classical tax regime, because the tax benefit tended to make up for the dilution risk. With rate parity, adverse selection becomes a more active possibility respecting OMR programs. The Article concludes that the shift to repurchases should not be read as a governance success story. Since repurchases held out tax benefits for most shareholders prior to the JGTRRA, there was no reason for outside monitors to ask hard questions about flexibility and adverse selection or to inquire further about the motivational effects of stock option valuation. With rate parity, the governance system needs to start the questioning process. The bargain repurchase possibility must be weighed against the adverse selection possibility, with the balance depending on the state of the market. Taxation remains a consideration: Repurchases and capital gains still hold out deferral value for long term, taxpaying shareholders. Finally, special dividends hold out advantages of transparency with the possible spillover of improved executive compensation policy. More generally, the JGTRRA poses a cost-benefit puzzle to be solved firm-by-firm, case-by-case. Unfortunately, the corporate governance system still rubber stamps management payout decisions, and so probably will fail to confront the questions. Governance reform is needed to assure that the payout decision is uncoupled from perverse incentives stemming from stock option compensation and reformulated in light of rate parity. It follows that payout should join management compensation in the emerging regime of governance by independent director committee.
Abstract: This paper examines the impact of increased corporate mobility on corporate lawmaking in the European Union (EU). More specifically, we seek an answer to a simple question: Has the increased mobility which arose from the implementation of the Societas Europaea (SE) and the path-breaking decisions of the European Court of Justice (ECJ) led to an outbreak of regulatory competition and the emergence of a Delaware-like member state in Europe? Two types of corporate mobility are distinguished: (1) the incorporation mobility of start up firms and (2) the reincorporation mobility of established firms. As to incorporation mobility, the Centros triad of cases makes it possible for start-up firms to incorporate in a foreign jurisdiction. Many entrepreneurs have taken advantage of this new freedom of establishment. However, recent data from Germany and The Netherlands indicate declining numbers of such foreign incorporations over time. Moreover, Centros-based incorporation mobility is a rather trivial phenomenon, economically speaking. The actors in question seek only to minimize costs of incorporation. National lawmakers have been responding, amending their statutes to lower these costs. But, because out of pocket cost minimization at the organization stage operates as only a secondary motivation of 'choice-of-business-form' decisions, there arise no competitive pressures that cause national legislatures to engage in thorough-going reform addressed to corporate governance more generally. As to reincorporation mobility, which concerns the migration of the statutory seat of a firm incorporated in one member state to another member state, the SE has opened the door, but not widely enough to serve as a catalyst for company law arbitrage. Reincorporation mobility is still far from generally available in the EU. As a result, competitive pressures do not yet motivate changes in the fundamental governance provisions of national corporate law regimes.
corporate mobility, costs of regulation, regulatory competition
Abstract: This paper applies the economic theories of fiscal federalism and jurisdictional competition to the question whether the juridical presumption favoring decentralization of authority manifested in the European Union's subsidiarity principle has been rebutted in the case the Code of Conduct on Business Taxation. The Code is a pending EU tax coordination initiative that identifies and prohibits a zone of distortionary member state competition respecting taxation of capital. Evaluation of the Code under subsidiarity gives rise to three questions: (1) Whether subsidiarity's decentralization presumption implies a further presumption favoring tax competition; (2) whether subsidiarity's decentralization presumption can be overcome by a purely theoretical showing of distortionary effects of tax competition; and (3) whether, if empirical evidence of distortionary effects is required, the coordination legislation in question must address the empirically-established distortion with adjudicative particularity. The paper reaches a firm answer as to question (1): Subsidiarity does not favor tax competition, remaining neutral on the subject. It brings fiscal federalism theory to bear in reaching this conclusion: Under fiscal federalism the list of legitimate central government functions lengthens as a minimal federation like the EU successfully brings about economic integration by opening national borders to free movement. As member state economies become less heterogeneous and economic interconnections between them increase in number and depth, member state economic policies, particularly taxing and spending policies, cause more fiscal externalities. Fiscal federalism theory also describes allocative inefficiencies in competitive tax systems, particularly with respect to corporate income and commodity taxes, and highlights negative distributional consequences of tax competition. Coordinative initiatives directed to the elimination of resulting inefficiencies in resource allocations therefore hold a legitimate place on the EU's integration agenda. The paper's answers for questions (2) and (3) are more qualified. The strength of both subsidiarity's decentralization presumption and of any rebuttal case depend on political risks and economic factors specific to the situation. In the tax coordination case addressed, the risks turn out to be low, permitting the presumption to be rebutted by a strong theoretical case articulated on a spotty empirical record.
Abstract: This paper examines the law and economics of downside arrangements in venture capital contracts. Downside protection for a venture capitalist means two things-first, power to replace the firm's managers (or alternatively, to force sale or liquidation of the firm), and, second, power to protect the venture contract itself from opportunistic amendment. Recent empirical work by Kaplan and Stromberg shows that venture capital investments possess this protection in varying degrees, depending on the mode of their participation and the governing contracts' terms. The venture capitalist remains vulnerable in a significant number of cases, lacking voting and boardroom control and relying entirely on terms articulated ex ante in the preferred stock contract. In these cases, there arises a risk of exposure to issuer opportunism in downside situations. The paper evaluates this risk, reviewing contract terms employed in venture capital transactions and the caselaw on preferred stock. A mixed picture emerges. The terms of venture capital contracts improve in significant respects on those of traditional preferred stock contracts. But they are not perfect and offer incomplete protection from issuer opportunism. Meanwhile, the caselaw is as hostile as ever. Delaware has taken the lead, sustaining a classic case of preferred stock victimization in a venture capital context. The paper criticizes this approach as a matter of both contract law and contract economics. Contract law's good faith duty can be used to protect venture capital preferred without a cognizable risk of unproductive judicial interference in corporate affairs. Furthermore, under the economics of incomplete contracts, where subject matter is noncontractible a blanket presumption against ex post intervention on the ground of forced contract is incoherent. Drawing on the control transfer model of Aghion and Bolton, the paper shows that efficient results and the interests of senior securityholders are aligned in a larger set of cases than previously supposed. Accordingly, when disputes between venture capitalists and entrepreneurs come to court, a rote presumption favoring the common stockholder is not defensible on efficiency grounds.
Abstract: The Sarbanes-Oxley Act and the Securities Exchange Commission move too quickly when they prod the Financial Accounting Standards Board, the standard setter for US GAAP, to move immediately to a principles-based system. Priorities respecting reform of corporate reporting in the US need to be ordered more carefully. Incentive problems impairing audit performance should be solved first through institutional reform insulating the audit from the negative impact of rent-seeking and solving adverse selection problems otherwise affecting audit practice. So long as auditor independence and management incentives respecting accounting treatments remain suspect, the US reporting system holds out no actor plausibly positioned to take responsibility for the delicate law-to-fact applications that are the hallmarks of principles-based systems. Principles, taken alone, do little to constrain rent-seeking behavior. In a world of captured regulators, they invite applications that suit the regulated actor's interests. Rules, with all their flaws, better constrain managers and compromised auditors. Broadbrush reformulations of rules-based GAAP should follow only when institutional reforms have succeeded.
Corporation and securities law, illegal behaviour, enforcement of law, accounting, auditing
Abstract: This article examines contractual protection of unsecured financial creditors in US credit markets. Borrowers and lenders in the United States contract against a minimal legal background that imposes the burden of protection on the lender. A working, constantly updated, set of contractual protections has emerged in response. But actual use of available contractual technology varies widely, depending on the level of risk and the institutional context. The credit markets sort borrowers according to the degree of the risk of financial distress, imposing substantial constraints only on the borrowers with the most dangerous incentives. At the same time, the contracting practice is sticky and lumpy, never quite managing to conform to the predictions of first generation agency theory. Levels of protection vary with institutional contexts. Exhaustive contracts providing something approaching complete protection against agency costs prove feasible only in relational contexts conducive to ongoing renegotiation over time due to small numbers of lenders operating under reputational constraints. The public bond markets do not hold out such a process context, and accordingly shut out the riskiest borrowers. The larger, less risky firms that do gain access to the bond markets borrow under contracts offering incomplete protection, with the level of protection roughly correlating to the borrower's risk level. This leaves bondholders confronting a residuum of agency costs and relying on secondary protections like monitoring, exit, diversification, and hedging. This has worked reasonably well in practice, subject to an historical exception concerning the risk of high-leverage restructuring. The bond markets searched for two decades for a stable solution to this problem, finally settling on across-the-board contractual protection only in recent years.
agency costs, bank loans, bonds and bondholders, bond covenants, creditors' rights, legal capital, private placements, trust indentures
Abstract: The principal-agent characterization resonates especially well in both corporate law and economics because it cabins the problem of auditor responsibility within these fields' paradigms for describing and regulating duties within the firm. This article questions the practice of framing the problem of auditors' professional responsibility inside the principal-agent paradigm, even as it accepts the story of the dirty deal. The questions about the agency framework follow from an inquiry into the operative notion of the shareholder beneficiary. The article unpacks the notion of the shareholder and tells a particularized story about the shareholder interest. The exercise complicates the agency description, which tends to assume a unitary model of the shareholder. Under this article's analysis, multiple and unstable shareholder demands displace the unitary shareholder interest. This fragmented and volatile model of the shareholder does not provide a basis for articulating a coherent set of instructions respecting aggressive accounting and earnings management. This article endorses traditional notions of auditor independence even as it rejects the fiduciary-beneficiary framework. One cannot "stand separate and apart" from the client's business and at the same time be an agent beholden to the shareholder interest. If we want auditors to be independent, we cannot enmesh them in an agency relationship with the shareholders, where by definition they become subject to the principal's control and cannot act independently. Nor, for the same reason, should auditors' duties be articulated in the framework of corporate law fiduciary duty. More generally, auditor responsibility should not be conceived relationally at all. This article concludes that legal positivism provides a more appropriate conceptual framework. Auditor duties should be conceived in formal rather than relational terms, with fidelity going to the rules, to the texts, to the system that auditors apply.
Abstract: This Article offers a positive political economy of corporate federalism. It draws on the history of corporate law and basic concepts of evolutionary game theory to locate the content of corporate federalism in two stable equilibriums. The first equilibrium prevails in the charter market, following from Delaware's successful pursuit of an evolutionarily stable strategy to maximize rents from the sale of charters. The strategy, first followed by New Jersey, caused a radical change in corporate law in the late nineteenth century. Since then, stability has ruled. Corporate law's basic, enabling outline changed little during the twentieth century. Operative incentives, market structure, and regulatory results have been more constant than dynamic, even as Delaware often has adjusted its strategy as it has adapted to events. The second equilibrium is more political than economic and prevails among the makers of national corporate law - Congress, the Securities and Exchange Commission, the stock exchanges, and the federal courts. These actors react to events in a more volatile manner. But even here equilibrium has prevailed since 1934. In theory, under the prevailing norm, national regulation covers the securities markets and mandates transparency respecting firms with publicly traded securities while internal corporate affairs are left to the states. In practice, federal lawmakers sometimes disregard the norm, entering into internal affairs as the national system grows episodically. This national intervention into internal affairs is inevitable because Delaware follows an evolutionarily stable strategy that constrains its ability to respond to shocks that create national political demands. But national regulators follow a norm of cooperation even as they make these incursions. Federal regulators never structure interventions so as to disrupt the state equilibrium. They leave Delaware in place, along with its stable strategy and its rents. The Article asserts that this is the core of the federalism, a view that contrasts with a prevailing subject matter-based conception. From this perspective, the threat of disabling federal intervention has sunk into the deep constitutional structure, leaving Delaware safe in the present context.
corporate law, corporate federalism, Delaware, shareholder value, fiduciary law
Abstract: Many corporate law discussants think of themselves as picking up where Adolf Berle and E. Merrick Dodd left off in a famous, precedent-setting debate in the 1930s. The generally accepted historical picture puts Berle in the position of the original ancestor of today's shareholder primacy position while Dodd is cast as the original ancestor of today's corporate social responsibility (CSR). This Article shows that both categorizations amount to mistaken readings of old material outside of its original context. The Article corrects the mistakes, offering new readings of some of corporate law's fundamental texts, texts that recently reached their 75th anniversaries and include Berle's famous book with Gardiner C. Means, The Modern Corporation and Private Property. Seventy-five years ago the normative issue of the day was the appropriate policy response to the crisis of the Great Depression. Both Berle and Dodd addressed the issue from a corporatist perspective which views the corporation as an entity that operates as an organ of the state and assumes social responsibilities. In so doing Berle took on the fundamental question "for whom is the corporation managed" at a time when the answer had crucial implications for social welfare. In answering the question, Berle articulated a political economy that integrated a theory of corporate law within a theory of social welfare maximization. It was a great accomplishment, but it was in a context very different from today's debates about corporate management and responsibility. Accordingly, Berle was not advocating shareholder primacy as we understand it today. Nor is there a strong claim that Berle was a CSR advocate; he never did make the final jump of advocating reorganization of the legal firm as a social welfare maximizer. His unqualified statements on the subject all presupposed a strong regulatory state and a public consensus against a corporate profit maximand. Dodd does not present a clear picture either. Dodd's Depression-era writing, once contextualized, offers only indirect support to today's CSR advocates. He is most plausibly read as a managerialist, and social responsibility within management's discretion is not what CSR tends to be about. The biggest lesson from this analysis is that the shareholder primacy school impairs its own position by making a claim on Berle.
Adolf Berle, E. Merrick Dodd, corporate social responsibility, CSR, shareholder primacy, social welfare
Abstract: In April 2002 the International Monetary Fund introduced a sovereign bankruptcy proposal only to be rebuffed by the United States Treasury. Where the IMF wanted a mandatory bankruptcy regime, the Treasury wanted to solve distress problems with contractual devices. Sovereign bondholders and sovereign issuers themselves flatly rejected both proposals, even though they were nominally the beneficiaries of both proponents. This Article addresses and explains this bondholder reaction. In so doing, it takes a highly skeptical view of the IMF's proposal even as it shows that the incentive structure surrounding sovereign lending renders untenable the Treasury's contractarian proposal. The Article's analysis follows from a review and restatement of the economic learning on sovereign debt relationships. The IMF and the Treasury share the objective facilitating restructuring by substituting a regime of collective action for the prevailing practice of requiring unanimous bondholder consent to significant amendments of bond contracts. In so doing they follow a conventional wisdom respecting bond contracts under which standard unanimity provisions are inefficient and irrational. The Article shows that this dismissal of the unanimity requirement comes too quickly. Under our analysis of the problem the debtor distress, bondholders rationally may prefer to make compositions harder to conclude. There is no first best equilibrium bond contract; instead bondholders select from a menu of second best forms, making trade offs between unanimous action and collective action provisions in an imperfect world. One factor leading lenders to favor unanimous action is the need to self protect. In a world without a good faith backstop, creditors motivated by side deals can take advantage of majority rule to impose suboptimal compositions. Holding out is the only weapon available to the minority creditor. The Article argues that, given such side deals, a stable majoritarian regime cannot be achieved as a matter of free contract. Mandate will be necessary. It follows that the Treasury's contractarian approach is implausible absent a backstop regime of intercreditor good faith duties. The Article draws on the history of corporate reorganization prior to the enactment of the section 77B of the Bankruptcy Act of 1934 to show that courts have grappled with these questions before, intervening aggressively on equitable principles.
Abstract: The Financial Accounting Standards Board (FASB) presents a puzzle for those interested in the design of private governance institutions: How has this private standard-setter managed simultaneously (1) to remain independent and free of capture, (2) to achieve institutional stability and legitimacy, and (3) to operate in a politicized context in the teeth of opposition from its own constituents? This Article looks to governance design to account for this institutional success. The FASB's founders made a strategic choice between two models of a public regulatory agency, the New Deal model of an independent expert and the post-war pluralist model of a politically responsive regulator. They opted for the New Deal model, structuring the FASB to emphasize independence. Because the New Deal model calls for a normative goal to channel the agency's exercise of discretion, they also undertook to set out a coherent theory of accounting, the "Conceptual Framework," to contain and direct the FASB's decisions and thereby import legitimacy. The Conceptual Framework, however, neither determined nor justified the FASB's subsequent decisions. It nonetheless contributed to the FASB's institutional success by disavowing a neutral posture respecting the conflicting interests of the FASB's leading constituents, explicitly privileging the interests of the users of financial reports (investors and market intermediaries) over the interests of the reports' preparers (large firms and their managers). The FASB's consistent adherence to this repudiation of pluralist responsiveness has had three results. First, it made the FASB's general approach defensible as a matter of economic theory. Second, it triggered political opposition from the preparers that muted allegations of capture even as it resulted in occasional political reversals. Third, it aligned the FASB's institutional mission with that of the SEC, its public overseer, importing institutional stability if not political invulnerability. The FASB remains vulnerable to a secondary capture allegation. Critics charge that its complex, rules-based standards serve the audit firms' interest in lowering the risk of liability while sacrificing the users' interest in "fairly" stated financials; "principles-based" standards would be better. This Article endorses the rejoinder position. What some see as capture also can be characterized as "responsiveness," and the FASB serves a public interest in taking seriously the accounting firms' need for auditable standards. Even as detailed rules can distort the overall story told by a report's bottom line, they make it easier to see what preparers are doing, easing verification and making audit failures and scandals less likely. In this post-Enron era, scandal prevention arguably takes a legitimate place with transparency as a public-regarding goal for the GAAP setter. The FASB emerges as a generator of suboptimal but institutionally-defensible standards. If not ideally legitimate, the FASB has been legitimate enough.
Accounting, Securities Regulation, Administrative Law
Abstract: In their new book, Pay without Performance: The Unfulfilled Promise of Executive Compensation, Lucian Bebchuk and Jesse Fried describe in detail the performance insensitivity of today's executive incentive compensation packages. The authors assert that managers possess and effectively wield power, assuring that so-called incentive pay comes on easy terms. Kevin Murphy and Michael Jensen, who together provided crucial academic impetus for the 1990s movement to equity based compensation, along with other economists, respond in defense of prevailing practice. This review of Pay without Performance reports on the state of play in this academic tournament. It finds that even as both sides score points, significant concessions have been accreting on the defensive side. The result is a clear victory for Bebchuk and Fried. They win the match when the defense acknowledges that management power matters. The concession changes the terms of discourse in a field that expunged the concept of power from its positive account more than two decades ago. With power back in the positive account, the burden of persuasion shifts from the critics to the defenders of prevailing practices. The question then turns to whether prevailing pay practice can be improved materially. When the answer turns out to be yes, the debate ends in favor of Bebchuk and Fried.
Abstract: This Article interrogates the possibility that pari passu clauses in sovereign debt contracts legitimately can be read broadly so as to require pro rata payments to foreign creditors by sovereigns in default and forbid payments to favored classes of creditors. Many subscribe to a narrow interpretation, under which the clauses cover only contractual and legal priorities and do not regulate payments. The narrow interpretation makes sovereign debt compositions easier to conclude by depriving holdout creditors of a disruptive enforcement tool, arguably benefiting the bondholders as a group. This Article highlights benefits for the bondholders as a group under the broad reading, shifting to an ex ante time perspective and situating the clause in the economic context of sovereign lending. Debt contracts benefit sovereign bondholders in three ways when they create frictions that retard later compositions. First, the contracts diminish the likelihood of default by opportunistic sovereigns seeking to externalize the effects of economic reverses. Second, assuming severe financial distress, they make it less likely that the defaulting sovereign will attempt to impose the burden of restructuring on the particular class of bonds. Third, assuming a restructuring, they improve the bondholders' bargaining position. More generally, the pari passu clause, read broadly, constrains the distressed sovereign's range of choices, enhancing the enforcement power of the bonds, and arguably lowering the long run cost of sovereign debt capital. The Article depicts sovereign debt as a world of tradeoffs and contradictions, where a contract that makes the bondholders better off means one thing on the day it is executed and delivered and another thing in the event of severe distress later on. With private debt, such contradictions are surmounted through the intervention of the bankruptcy regime. With sovereign debt there is no bankruptcy, forcing the parties to paper over the tensions between ex ante and ex post by drafting vaguely. Intractable questions of interpretation arise in consequence. From this perspective, judicial attachment of the broad reading can be justified without being dictated and without the narrow reading being rendered implausible or illegitimate. The interpreting court must choose between the readings under uncertainty.
Abstract: This essay comments on William Klein's Criteria for Good Laws of Business Association. Klein bids us to cull, modify, and restate a set of proposed criteria for good corporate law so as to state the law's goals more clearly. This essay takes up the invitation. It suggests that the criteria on which we can agree lie at a high level of generality: Corporate law makes us all welfare consequentialists who agree that good corporate law is about encouraging productivity. We differ over the means to that end in debates that have over time evolved away from the ideological and toward the functional. Within this framework, corporate law has two core and generally accepted objectives - freedom of action for management and the minimization of the cost of capital. The firm's legal boundaries follow from these core objectives, and adherence to them triggers resistance to theoretical calls for social responsibility and constituent empowerment. In contrast, corporate law's core subject matter, the terms of the shareholder-manager agency relation, implicates tensions between the dual purposes of freedom of action for management and the minimization of the cost of capital. Corporate law mediates these tensions with open-ended terms and piecemeal resolutions. Although theorists have offered meta level means to resolve the tensions, the practice has never responded by endorsing the theories. Absent an ex ante set of empirically verifiable formulas for productive business organization, this debate will continue unresolved.
Abstract: The Securities Exchange Commission has introduced a Roadmap that describes a process leading to mandatory use of IFRS by domestic issuers by 2014. The SEC justifies this initiative on the grounds that global standardization yields cost savings and an ultimate gain in comparability, facilitating the search for global opportunities by U.S. investors and making U.S. capital markets more attractive to foreign issuers. This paper enters an objection, noting that the stakes include more than the choice of the framework for standard setting. The accounting treatments themselves are at issue, treatments that for the most part concern domestic reporting firms and domestic users of financial statements. We present a treatment by treatment comparison of GAAP and IFRS and go on to discuss the differences' implications. FASB maintained its independence during its 35 year history in the teeth of opposition from corporate management, which experienced a steady diminution of its zone of financial reporting discretion. A switch to IFRS would allow management to reclaim some of the lost territory. Meanwhile, the interest group alignment that protected FASB, comprised of auditing firms, actors in the financial markets, and the SEC, has disintegrated as U.S. capital market power has waned in the face of international competition. Management is the shift's incidental beneficiary, with possible negative effects for reporting quality in domestic markets.
GAAP, IFRS, FASB, Securities Exchange Commission
Abstract: Many look toward enactment of the law reform agenda held out by proponents of shareholder empowerment as a part of the regulatory response to the financial crisis. This Article argues that the financial crisis exposes major weaknesses in the shareholder case. Our claim is that shareholder empowerment delivers management a simple and emphatic marching order: manage to maximize the market price of the stock. And that is exactly what the managers of a critical set of financial firms did in recent years. They managed to a market that focused on increasing observable earnings and, as it turned out, failed to factor in concomitant increases in risk that went largely unobserved. The fact that management bears primary responsibility for the disastrous results does not suffice to effect a policy connection between increased shareholder power and sound regulatory reform. A policy connection instead turns on a counterfactual question: Whether increased shareholder power would have imported more effective risk management in advance of the crisis. We conclude that no plausible grounds exist for making such a case. In the years preceding the financial crisis, shareholders validated the strategies of the very financial firms that pursued high leverage, high return, and high risk strategies and penalized those that did not. It is hard to see how shareholders, having played a role in fomenting the crisis, have a positive role to play in its resolution.
The prevailing legal model of the corporation strikes a better balance between the powers of directors and shareholders than does the shareholder-centered alternative. Shareholder proponents see management agency costs as a constant in history and shareholder empowerment as the only tool available to reduce them. This Article counters this picture, making reference to agency theory and recent history to describe a dynamic process of agency cost reduction. It goes on to show that shareholder empowerment would occasion significant agency costs on its own by forcing management to a market price set in most cases under asymmetric information and set in some cases in speculative markets in which heterogeneous expectations obscure the price’s informational content.
Corporations, corporate governance, financial crisis, law reform, regulatory reform, shareholder wealth maximization, shareholder primacy, risk management, leverage, high risk strategies, balance of power between directors and shareholders, agency costs
Abstract: These are the edited proceedings of a conference convened in November 2003 by the Sloan Project on Business Institutions at the Georgetown University Law Center to discuss the post-Enron crisis of confidence in the corporate governance system. The participants discuss a number of topics, including changes in the role of the board of directors, accounting system reform, recent amendments of the federal securities laws, executive compensation, and the governance functions of market intermediaries, institutional investors, and corporate counsel. Academic participants include Dean Joel Seligman and Professors John C. Coffee, James Cox, Lynne Dallas, Charles Elson, Stuart Gillan, Robert Haft, Steven Kaplan, Neal Katyal, Lynn Stout, and Shyam Sunder. Participants from the accounting profession include G. Michael Crooch, George Diacont, and Dennis Nally. Participants from the business world include John Bogle, Ed Kwalwasser, Claudine B. Malone, Roger Raber, Robert Rosenberg, Charles Rossotti, and Thomas Selman. Participants from the legal profession and the judiciary include Charles Davidow, Eric Dinallo, Damon Silvers, Paul Saunders, Vice-Chancellor Leo Strine, John Villa, and Peter J. Wallison.
Abstract: This Article intervenes in the debate over executive compensation to assert that evaluation of prevailing practices concerns more than the quality of the bargaining space. The discussants posit shareholder value maximization as the firm's objective and agree that value can be enhanced by aligning management's interests with those of the shareholders. They tend not to address the follow up question as to how the shareholder should be modeled for the purpose of incentive design. This Article unpacks the unitary notion of the shareholder into a differentiated cast of characters made up of investors, speculators, noise traders, fundamental value investors, short term holders, long term holders, dumb money, and smart money. Most will agree that compensation should be designed so as to encourage managers to take the view of a long term, fundamental value investor. Despite this, prevailing practices invite alignment of management interests with those of short term speculators. Perverse effects result for investment policy, payout policy, and the quality of financial reports, particularly when the market overvalues the firm's shares. Although long term restraints on alienation on equity grants would substantially ameliorate these problems, they are not seen in practice because they diminish the value of equity grants by impairing liquidity and inhibiting diversification. A persistent question emerges: At the margin, what is the purpose of incentive compensation, to incentivize or to compensate? To the extent that the answer is "both" rather than "incentive compatibility," perverse effects remain a constant possibility. Leaving the matter over to case-by-case negotiation in an appropriate bargaining environment holds out an incomplete solution. Nor would shareholder empowerment solve the problem of perverse effects because the behavioral shortcomings of shareholders create the problem in the first place.
Abstract: This Article marshals a new case for invalidating English Only regulations, which take the form of (a) "Official English," statutes that elevate English to "official" status as the language of government, and (b) "Workplace English," employer regulations, widespread in American workplaces and sustained by federal courts, that mandate English speech at all times on pain of termination. The Article centers on Latinos and Latinas to make a case for invalidation built on the value of linguistic and cultural identifications to the individual person. It shows that English Only violates the basic right of personality of non-English speaking and bilingual Americans without yielding anything of cognizable value to American society as a whole. The case has two phases. The first phase of the case approaches value from the point of view of the person as modeled in economic theory. It draws on the economics of language difference and the economics of discrimination to undercut the cost justification for state language mandates designed to encourage immigrant assimilation and demonstrate the cost feasibility of legal intervention against Workplace English. These economics imply a complex description of the incentives of Latino and Latina immigrants. On the one hand, there remains every reason to apply the traditional view that market incentives are sufficient to assure that Latinos and Latinas learn English with a view to participating in the mainstream economy. So doing rebuts the nativist characterization of a foreign-language threat to American civilization--spontaneous order appears to be adequate to the job here. On the other hand, the economics provide no basis for predicting that the economic opportunities available to Latinos and Latinas import present incentives to disperse across the continent in the manner of earlier immigrant generations. Discrimination by white Anglos limits both their returns on human capital investment and their incentive to assimilate. Meanwhile, the economic theory of discrimination fails to support a prediction that free markets necessarily will cause this problem to disappear over time. Workplace English emerges in this analysis as indistinguishable from other discriminatory conduct barred by Title VII. Title VII coverage may be costly, however: Discriminatory employer practices may be cost reductive, and enforcement increases employer operating costs. But the ultimate cost-benefit result can depend on who bears the costs. The Article projects that the costs, modest in the first place, will be borne by Latinos and Latinas themselves, who will not differ from other Americans so far as concerns a willingness to bear the costs of life in a free and equal society. The second phase of the Article's case approaches value from the point of view of a person as modeled in Kantian moral and political theory. It sets out in detail a theory of right that compels the accordance of suspect status to discrimination based on language. Here the Kantian ideal of the free person is connected with a description of the constitutive role identifications play in any human being's struggle to live out her life. Language rights are justified through an interpretation of what it means to treat each individual as a free person with equal dignity. This justification is grounded in turn in a description and defense of the ideal of the imaginary domain. This demands that each individual be given the moral and psychic space to evaluate, represent, and ultimately to integrate the complex realities of culture, linguistic origin, national affiliation, ethnic identity, and religious heritage. Language accordingly should be treated as a fundamental identification encompassed by each person's right of personhood. It follows that a legal system that treats Latinos and Latinas as equals recognizes them as the source of the value they bestow on the Spanish language. In contrast, an English Only regime designed to force Latinos and Latinas to speak the majority tongue in public life or in the workplace treats them as less than free persons, thereby degrading them and violating their imaginary domains. In the course of articulating this position, the Article addresses recent, more general debates on cultural rights. The Article declines to join these discussants in debating the truth about the constitution of the post-modern subject because its argument does not require an answer to the question of who we really are as subjects. This is because its central point is that such basic decisions about the meaning of identification must be left to individuals as they struggle to form their own lives. It argues that the focus of legal debates about minority rights and multiculturalism should shift away from the question as to the truth of the subject and instead ask how and why state recognition of the person demands the right of personhood. Thus changing the question allows us to rethink the ethical stakes in debates about identity politics without attaching ourselves to a simplistic or, worse yet, naturalized conception of identity. Once freedom occupies the foreground of the picture, questions about the relationship between language and culture will lead to complicated explanations. Yet this complexity in no way denies the need for language rights.
Abstract: Dividend and reinvestment policy has a history of chronic insusceptibility to direct regulatory improvement, whether by contract or mandate. This paper explains this result by reference to the economic literature that applies incomplete contracts analysis to the problem of optimal capital structure. These models teach, first, that intractable informational asymmetries prevent direct contractual solutions to the governance problem presented by dividend policy, and, second, that solutions can be structured only indirectly thorugh the control transfer provisions built into corporate capital structures. Unlike the standing agency explanation of dividend policy, this approach does not purport to offer a complete theoretical solution to the problem of suboptimal earnings retention. But it does explain the continuing absence of a tractable first-best solution: Given conditions of uncertainty, it follows from the nature of debt and equity that the precise measure of the optimal mix of the two will remain unknown. The paper also draws on the models to appraise the three items on the standing menu of governance reform proposals respecting dividend and reivestment policy--specifically, mandatory payout of earnings, institutional investor monitoring, and stepped up disclosure requirements.
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