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Abstract: Comparative research has shown that, even at the level of the largest firms, corporate ownership structure tends to be highly concentrated, with dispersed ownership structures characterizing only the Anglo/American context. What explains these national boundaries between dispersed and concentrated ownership structures? Earlier in this decade, several authors (most notably, Mark Roe) proposed "political" theories of corporate finance under which dispersed ownership was viewed as largely the result (in the U.S.) of regulatory constraints imposed on the development of financial intermediaries. Under this view, a deep-rooted American political ideology disfavored concentrated financial power, with the alleged result that the Berle/Means model of the firm (with its characteristic "separation of ownership and control") became dominant in the U.S. (but not elsewhere). More recently, economists working on the privatization of transitional economies have focused on the difficulties in establishing viable securities markets. Based on survey data, they have concluded that common law regimes vastly outperform civil law regimes in fostering the development of equity markets. Even if this research is still at a preliminary stage, this data suggests an alternative "legal" hypothesis for the observed dichotomy between concentrated and dispersed ownership: namely, only those legal systems that provide significant protections for minority shareholders can sustain active equity markets. This "legal" hypothesis is the mirror image of the earlier noted "political" theory of corporate finance: under the "legal" hypothesis, dispersed ownership evidences not the overregulation of institutional investors, but the law?s success in encouraging investors to accept the status of minority owners. Similarly, financial intermediaries fail to grow to the scale observed in Japan and Germany, because individuals do not need to rely upon them as collective investment vehicles. These two contrasting theories yield very different predictions about the likelihood that globalization will produce significant convergence in corporate governance. Emphasizing the inertial impact of path dependency, proponents of the former political theory have focused on the barriers to formal convergence and been skeptical of the prospects for legislative change. Proponents of the "legal" hypothesis have yet advanced no logical corollary to their arguments, but this article examines an alternative and more likely route to significance convergence in corporate governance: namely, functional convergence attained, first, through the migration of foreign issuers to the U.S. securities markets and, second, through international harmonization of securities regulation and disclosure standards. Empirically, the migration of foreign issuers to the U.S. markets has accelerated in this decade, and this article examines several hypotheses for this trend, including (i) the possibility that a U.S. listing is a bonding mechanism by which issuers assure minority shareholders that they will not be exploited; (2) the existence of network externalities associated with securities exchange that attract issuers even in the face of high regulatory costs; and (3) the possibility that the "strong" position of management in the Berle/Means corporate structure protects minority shareholders from the danger that the subsequent formation of a control block will permit a new controlling shareholder to expropriate value from them. Finally, this article argues that convergence in corporate governance will occur not at the level of corporate laws, but at the level of securities regulation. In particular, it emphasizes the critical, but often overlooked, role for securities regulation in reducing agency costs. In this regard, developments in the United States may foreshadow future international corporate convergence, as, it is argued, the predominance of federal securities law has largely overshadowed variations in state corporate laws and rendered unimportant the competition among American states for corporate charters. Similarly, on the international level, securities harmonization may trivialize path dependent variations in national law.
Abstract: Between January 1997 and June 2002, approximately 10% of all listed companies in the United States announced at least one financial statement restatement. The stock prices of restating companies declined 10% on average on the announcement of these restatements, with restating firms losing over $100 billion in market capitalization over a short three day trading window surrounding these restatements. Such generalized financial irregularity requires a more generic causal explanation than can be found in the facts of Enron, WorldCom or other specific case histories. Several different explanations are plausible, each focusing on a different actor (but none giving primary attention to the board of directors): 1. The Gatekeeper Story looks to the professional "reputational intermediaries" on whom investors rely for verification and certification - i.e., auditors, analysts, debt rating agencies and attorneys - and views the surge in financial restatements as the product of both (a) reduced legal exposure for gatekeepers (as the result of legislation and judicial decisions in the 1990's sheltering them from liability) and (b) the increased potential for consulting income or other benefits from their clients (resulting in gatekeeper acquiescence in accounting or financial irregularities). This is essentially the story to which the Sarbanes-Oxley Act responds. 2. The Misaligned Incentives Story instead focuses on managers and a dramatic change in executive compensation during the 1990's, as firms shifted from cash to equity-based compensation. Stock options (and legal changes that enabled management to exercise the option and sell the security without any delay) arguably gave management a strong incentive to inflate reported earnings and create short-term price spikes that were unsustainable, but which they alone could exploit. Sarbanes-Oxley does not address this potential cause of irregularities. 3. The Herding Story focuses on the incentives of investment fund managers and argues that they are uniquely focused on their quarterly performance vis-a-viz their rivals. As a result, they have an incentive to "ride the bubble," even when they sense danger, because they fear more the mistake of being prematurely prophetic. Again, Sarbanes-Oxley does not address this cause of bubbles and price spikes. This comment compares and contrasts these explanations, finding them highly complementary.
Abstract: A wave of financial irregularity broke out in the United States in 2001-2002, culminating in the Sarbanes-Oxley Act of 2002. A worldwide stock market bubble burst over this same period, with the actual market decline on a percentage basis being somewhat more severe in Europe. Yet, no corresponding wave of financial scandals involving a similar level of companies broke out in Europe. Indeed, those scandals that did arise in Europe often had American roots (e.g., Vivendi, Ahold, Adecco, etc.). Given the higher level of public and private enforcement in the United States for securities fraud, this contrast seems perplexing. What explains this contrast? This paper submits that different kinds of scandals characterize different systems of corporate governance. In particular, dispersed ownership systems of governance are prone to the forms of earnings management that erupted in the United States, but concentrated ownership systems are much less vulnerable. Instead, the characteristic scandal in concentrated ownership economics is the appropriation of private benefits of control. Here, Parmalat is the representative scandal, just as Enron and WorldCom are the iconic examples of fraud in dispersed ownership regimes. Is this difference meaningful? This article suggests that this difference in the likely source of, and motive for, financial misconduct has implications both for the utility of gatekeepers as reputational intermediaries and for design of legal controls to protect public shareholders. What works in one system will likely not work (at least as well) in the other. The difficulty in achieving auditor independence in a corporation with a controlling shareholder may also imply that minority shareholders in concentrated ownership economies should directly select their own gatekeepers.
Abstract: Debacles of historic dimensions tend to produce an excess of explanations. So has it been with Enron, as virtually every commentator has a different diagnosis and a different prescription. Yet, in most respects, Enron is a maddeningly idiosyncratic example of pathological corporate governance, which by itself cannot provide evidence of systematic governance failure. Properly understood, however, the Enron debacle furnishes a paradigm of "gatekeeper failure" - that is, of why and when reliance may not be justified on "reputational intermediaries," such as auditors, securities analysts, attorneys, and other professionals who pledge their reputational capital to vouch for information that investors cannot easily verify. This comment shows that, during the 1990's, the expected liability costs associated with gatekeeper acquiescence in managerial misbehavior went down, while the expected benefits went up - with the unsurprising result that earnings restatements and earnings management increased. Diagnosing the circumstances under which "gatekeeper failure" is likely leads in turn to prescriptions focused on re-aligning the incentives of gatekeepers with those of investors.
Abstract: Deep and liquid securities markets appear to be an exception to a worldwide pattern in which concentrated ownership dominates dispersed ownership. Recent commentary has argued that a dispersed shareholder base is unlikely to develop in civil law countries and transitional economies for a variety of reasons, including (1) the absence of adequate legal protections for minority shareholders, (2) the inability of dispersed shareholders to hold control or pay an equivalent control premium to that which a prospective controlling shareholder will pay, and (3) the political vulnerability of dispersed shareholder ownership in left-leaning "social democracies". Nonetheless, this article finds that significant movement in the direction of dispersed ownership has occurred and is accelerating across Europe. But can this trend persist in the absence of strong legal protections for minority shareholders and in the presence of high private benefits of control? To understand how dispersed ownership might both arise and persist in the absence of the supposed legal and political preconditions, this article reconsiders the appearance of dispersed ownership in the late 19th and early 20th Century in the U.S. and the U.K. and contrasts their experience with those of France and Germany over the same period. During this era, the private benefits of control were high, and minority legal protections in the U.S. were notoriously lacking, as the famous Robber Barons of the age bribed judges and legislators and effectively employed regulatory arbitrage to escape even minimal anti-fraud regulation. Nonetheless, strong self-regulatory institutions (most notably, the New York Stock Exchange) and private bonding mechanisms by which leading underwriters pledged their reputational capital by placing directors on the board of sponsored firms enabled the equity market to expand and dispersed ownership to arise. In contrast, in the U.K., the London Stock Exchange for a variety of path-dependent reasons played a far more passive role and did not become an effective self-regulator until much later in the 20th Century. Yet, dispersed ownership also arose, although at a slower pace. The lesser role for private self-regulation in the U.K. may have been the consequence of its lesser need for self- regulation as a functional substitute for formal law, given both earlier legislation in the U.K. and lesser exposure to judicial corruption and regulatory arbitrage. In contrast to the New York and London Exchanges, the Paris Bourse over this same period made little, if any, effort to develop a self-regulatory structure or to upgrade listing or disclosure standards. Why not? The answer seems closely associated with the fact that it operated as a state-administered monopoly whose stockbrokers were formally considered civil servants and who were legally denied the ability to trade as principals for their own account. Facing no competition and composed of members having little incentive to promote or enhance its reputational capital, the Paris Bourse did not innovate and fell behind the London Stock Exchange. The intrusive role of state regulation, which discouraged private self-regulatory initiatives, appears to have a factor in its competitive decline. In Germany, the state strongly supported the growth of large private banks and enacted a punitive tax on securities transactions. Because the German central bank offered very liberal rediscounting terms to the principal private banks, they were able to satisfy the capital needs of German industry without resort to the equity market. In this respect, concentrated ownership seems less to have evolved naturally than to have been subsidized by the state. Prospectively, this article argues that "functional convergence" will dominate "formal convergence" and that the principal mechanism of functional convergence may be private self- regulation. However, rather than reject the "law matters" hypothesis, this article suggests that one of the principal advantages of common law legal systems is their decentralized character, which encourages self-regulatory initiatives, whereas in civil law systems the state may monopolize all law-making initiatives. Further, this article proposes that legal reforms, while important, are likely to follow, rather than precede, market changes - as happened in both the U.S. and the U.K. Once however a constituency for liquid and transparent securities market is thus created, it will predictably seek and secure legislation that fills in the enforcement gap that self-regulation leaves. Both in the U.S., the U.K. and Europe today, the growth of securities markets has been largely divorced from politics.
Abstract: This paper analyzes the comparative experiences of Poland and the Czech Republic with voucher privatization. Because of a number of similarities between these two transitional economies, it finds their comparative experience to provide a useful natural experiment, with the critical distinguishing variable being their different approaches to regulatory controls. However, while their experiences have been very different, their substantive corporate law was very similar. The true locus of regulatory differences appears then to have been the area of securities market regulation, where their approaches differed dramatically. Re-examining the work of LaPorta, Lopez-de-Silanos, Shleifer & Vishny, this paper submits that (1) the homogenity of both common law systems and civil law systems has been overstated; (2) common law systems in particular differ widely in terms of substantive corporate law, but have converged functionally at the level of securities regulation; (3) dispersed ownership will likely not persist under civil law systems that contemplate concentrated ownership and hence do not address or discourage rent-seeking corporate control contests or other forms of expropriation from minority shareholders; and (4) such "winner-take-all" control contests are probably most feasibly addressed through "self-enforcing" structural protections, such as (following the Polish model) the transitional use of state-created controlling shareholders. Reformulating the thesis originally advanced by LaPorta, et al., this article argues that civil law systems are not inherently unprotective of minority shareholders, but rather protect shareholders only against the forms of abuse that were well-known in systems of concentrated ownership (i.e., typically, abuse by a dominating parent) and not against the abuses that typically characterize systems of dispersed ownership (i.e., managerial expropriation and theft of the control premium). Ultimately, there is a conceptual mismatch between civil law systems and the dispersed ownership created by voucher privatization.
Abstract: Today, there are an estimated 150 securities exchanges trading stocks around the world. Tomorrow (or at least within the reasonably foreseeable future), this number is likely to shrink radically. The two great forces reshaping the contemporary world - globalization and technology - impact the world of securities markets in a similar and mutually reinforcing fashion: (1) they force local and regional markets into more direct competition with distant international markets; (2) they increase overall market capitalization and lower the cost of equity capital, as issuers are enabled to access multiple markets; and (3) they permit order flow and liquidity to migrate quickly from local markets to international "super-markets," sometimes with adverse consequences for smaller domestic markets. In overview, these consequences follow because globalization has lowered the barriers to cross-border capital flows, including in particular traditional restrictions on foreign investments in domestic stocks, while technology has made instantaneous information flows feasible, thereby enabling electronic securities markets to link dealers and markets participants around the world in continuous world-wide trading.
Abstract: During the 1990's, the phenomenon of cross-listing by issuers on international exchanges accelerated, with the consequence in the case of some emerging markets that trading followed, draining the original market of its liquidity. Traditionally, cross-listing has been viewed as an attempt to break down market segmentation and reach trapped pools of liquidity in distant markets. The globalization of financial markets, however, renders this explanation increasingly dated. A superior explanation is "bonding:" issuers migrate to U.S. exchanges in particular because by voluntarily subjecting themselves to the U.S.'s higher disclosure standards and greater threat of enforcement (both by public and private means), they partially compensate for weak protection of minority investors under their own jurisdiction's law and also credibly signal their intention to make fuller disclosure, thereby achieving a higher market valuation and a lower cost of capital. Still, many issuers who are eligible to cross-list do not do so. Increasing evidence suggests that cross-listing firms are significantly different from firms in the same jurisdiction that do not cross-list, most notably in that the former have higher growth prospects and are willing to sacrifice some of the private benefits of control to obtain equity finance. Conversely, firms that do not cross-list typically have controlling shareholders who have less interest in stock market valuation because they anticipate selling only in a control transaction at a control premium that they will disproportionately capture. As a result, specialized markets seem likely to persist in order to accommodate both firms that wish to offer superior protections to minority investors and those that prefer to cater to controlling shareholders who want to continue to realize the private benefits of control. Path dependency then may persist. The latest developments in this new form of regulatory competition have been both (i) the creation of new "high disclosure" exchanges in emerging markets, and (ii) the enactment of reform legislation intended to protect minority shareholders by jurisdictions that have seen their securities markets lose liquidity to international exchanges. Both efforts seek to share control premia with minority shareholders in order to encourage equity investment. However, such efforts appear to be impeded by the continuing willingness of U.S. exchanges to waive governance listing requirements that are mandatory for their domestic firms in the case of foreign firms. Finding this new form of regulatory competition to be desirable, this article argues that its distinguishing characteristic is that it is "exit-less" (and thus differs from the "issuer choice" model of regulatory competition), and it recommends that the current broad exemption under which U.S. exchanges waive all governance listing requirements for foreign issuers should be reconsidered.
Abstract: The role of "gatekeepers" as reputational intermediaries who can be more easily deterred than the principals they serve has been developed in theory, but less often examined in practice. Initially, this article seeks to define the conditions under which gatekeeper liability is likely to work - and, correspondingly, the conditions under which it is more likely to fail. Then, after reviewing the recent empirical literature on earnings management, it concludes that the independent auditor does not today satisfy the conditions under which gatekeeper liability should produce high law compliance. A variety of explanations - poor observability, implicit collusion, and high agency costs within the gatekeeper - provide overlapping explanations for gatekeeper failure. What remedy should work best to minimize such failures? As a more appropriate and supplementary remedy to reliance on class action litigation, this article recommends fundamental reform of the governance of the accounting profession. In particular, it contrasts the structure of self-regulation within the broker-dealer industry with the absence of similar self-discipline in the accounting profession. While such reform may be unlikely, its absence strongly implies that earnings management is likely to remain a pervasive phenomenon.
Abstract: The intensity of enforcement efforts by securities regulators varies widely among financially developed nations, but countries with "common law origins" appear to systematically expend more on securities regulation than countries with "civil law origins." However, whether this variable of relative enforcement intensity explains the greater financial development of countries with common law origins or is instead the product of that differential in development remains open to question and depends on the direction of causality. This paper examines several explanations and prefers the hypothesis that enforcement intensity is a product of the level of retail ownership in the jurisdiction, with a high level of retail ownership creating a political demand for greater enforcement. Even more striking than this disparity between "common law" and "civil law" countries, however, is the outlier position of the United States, whose public and private enforcement efforts dwarf those of other nations. The United States is unique not in its expenditures on securities regulation, but in the amount and severity of the penalties it imposes. Enforcement efforts can be sensibly measured either in terms of "inputs" (i.e., budget and staff size) or outputs (i.e., enforcement actions brought or financial sanctions levied). After adjustment for market size or GDP, the U.S. does not differ materially from other common law countries in its expenditures, but it brings far more enforcement actions and imposes far greater financial penalties. For example, in 2005/06, the financial penalties imposed by the SEC exceeded those imposed by the U.K.'s Financial Services Agency ("FSA") by a thirty to one ratio, which, even after adjustment for differences in market capitalization, still translates into a ten to one ratio. The greater emphasis on enforcement in the United States is also evident in a comparison of the budgets of the major securities regulators, with the SEC devoting a percentage of its budget to enforcement that more than doubles that of the FSA. Behind this varying emphasis on enforcement may lie different approaches to regulation: an "ex ante" advisory and consulting approach elsewhere and an "ex post," deterrence-oriented emphasis in the United States. The greater use of public enforcement in the United States is more than paralleled by corresponding disparities in private enforcement and the use of the criminal sanction. Virtually alone, the United States recognizes the class action and the contingent fee. The actual financial sanctions imposed by private enforcement in the United States exceed those imposed by public enforcement, and the margin appears to be increasing. The only nation to rival the U.S. among "common law origin" countries is Australia, which actually devotes a higher percentage of its securities regulator's budget to enforcement and also uses the criminal sanction heavily. Australia is also characterized by a high level of retail ownership. What has been the consequence of this greater emphasis on enforcement in the United States? Much recent commentary has suggested that it has deterred foreign issuers from entering the U.S. and threatened U.S. capital market competitiveness. Closer examination suggests, however, that the firms most deterred from cross-listing have been firms with controlling shareholders and a pattern of extracting high private benefits of control. Foreign issuers that do cross-list in the United States incur a cost of capital reduction averaging 13% and a valuation premium (measured in terms of Tobin's q) that is 32% greater than that of non-cross-listing firms. Although the cross-listing decision involves a complex interaction of bonding, signaling, self-selection, and reduced informational asymmetry, the overall evidence supports the "bonding hypothesis" and suggests that U.S.'s greater emphasis on enforcement reduces informational asymmetry and gives it a lower cost of equity capital.
Abstract: Recent commentary has argued that deep and liquid securities markets and a dispersed shareholder base are unlikely to develop in civil law countries and transitional economies for a variety of reasons, including (1) the absence of adequate legal protections for minority shareholder, (2) the inability of dispersed shareholders to hold control or pay an equivalent control premium to that which a prospective controlling shareholder will pay and (3) the political vulnerability of dispersed shareholder ownership in left-leaning "social democracies." Nonetheless, this article finds that significant movement in the direction of dispersed ownership has occurred and is accelerating across Europe. To understand how dispersed ownership can arise in the absence of the supposed legal and political preconditions, this article reconsiders the appearance of dispersed ownership in the late 19th and early 20th Century in the U.S. and the U.K. During this era, the private benefits of control were high, and minority legal protections in the U.S. were notoriously lacking, as the famous Robber Barron of the age bribed judges and legislators and effectively employed regulatory arbitrage to escape regulation. Nonetheless, strong self-regulatory institutions (most notably, the New York Stock Exchange) and private bonding mechanisms by which leading underwriters pledged their reputational capital by placing directors on the board of sponsored firms enabled the equity market to expand and dispersed ownership to arise. In contrast, in the U.K., the London Stock Exchange for a variety of path-dependent reasons played a far more passive role and did not become an effective self-regulator until much later in the 20th Century. Yet, dispersed ownership also arose, although at a slower pace. The lesser role for private self-regulation in the U.K. may have been the consequence of its lesser need for self-regulation as a functional substitute for formal law, given both earlier legislation in the U.K. and lesser exposure to judicial corruption and regulatory arbitrage. Based on these examples, this article argues that "functional convergence" will dominate "formal convergence" and that the principal mechanism of functional convergence may be private self-regulation. However, rather than reject the "law matters" hypothesis, this article suggests that one of the principal advantages of common law legal systems is their decentralized character, which encourages self-regulatory initiatives, whereas civil law systems may monopolize all law-making initiatives. Further, this article proposes that legal reforms, while important, are likely to follow, rather than precede, market changes - as happened in both the U.S. and the U.K. Once however a constituency for liquid and transparent securities market is thus created, it will predictably seek and secure legislation that fills in the enforcement gap that self-regulation leaves. Both in the U.S., the U.K. and Europe today, the growth of securities markets has been largely divorced from politics. What then are the preconditions for the separation of ownership and control? The key answer is that public shareholders be able to retain control, protected from the threat of stealth raiders who can assemble controlling blocks without paying a control premium. In both the U.S. and the U.K., these protections were first developed through private (or semi-private) ordering and then formalized in legislation.
Abstract: Recent empirical work has found that the private benefits of control differ significantly depending upon the underlying legal system in which the firm is incorporated. In particular, common law systems appear to outperform French civil law systems, but are trumped in turn by Scandinavian civil law systems. This evidence could be read to support the "law matters" thesis first advanced by Professors LaPorta, Lopez-de-Silanes, Shleifer and Vishny, which finds that "common law" legal systems incorporate superior legal protections for minority shareholders and therefore have deeper capital markets and more dispersed ownership. But the apparent superiority of Scandinavian legal systems complicates, and possibly subverts, this analysis, both because Scandinavian legal systems are more "like" other civil legal systems than they are "like" common law legal systems and because Scandinavian law does not encourage private enforcement of law through class actions and similar devices. Hence, an alternative hypothesis suggests itself: social norms in Scandinavia may discourage predatory behavior by those in control of the firm. This paper explores the competing merits of these two rival hypothesis - law versus norms as instruments of social control - by comparing the private benefits of control in various countries to other benchmarks, such as rates of criminal victimization. Although it finds no universal pattern, some strong congruences are discernible within particular legal systems (i.e., Scandinavian crime rates are very low, as are the private benefits of control that controlling shareholders expropriate from Scandinavian firms). A revised hypothesis is thus suggested: crime rates and the private benefits of control are the lowest in countries having the highest level of social cohesion and the lowest level of recent social and political disruption. This explanation works well for countries with crime and high private benefits of control (e.g., Russia, Mexico, and Brazil), but less well for many common law countries (such as the U.S.) in which the private benefits are low, but crime is high. One implication of this comparison is that the impact of norms may be greatest when law is the weakest. This possibility may explain best why behavior within Scandinavian firms is different from that in French civil law firms, when both share relatively weak legal rights.
Abstract: Securities markets have long employed "gatekeepers" - independent professions who pledge their reputational capital - to protect dispersed investors. This strategy of relying on reputational intermediaries to assess, verify and certify the corporate issuer's disclosures appears to have failed during the late 1990s, as accounting irregularities increased exponentially. Part I of this paper assesses the reasons for this failure, emphasizing both a shortfall in deterrence and the sudden shift from a cash-based to an equity-based system of executive compensation during the 1990s. Part II and III then survey the realistic regulatory options and the incomplete steps taken by the Sarbanes-Oxley Act. Breaking down these options into four categories - structural rules, prophylactic rules, procedural rules, and liability-enhancing rules, - Part III concludes that simply increasing the threat of liability could cause the market for gatekeeping services to fail. Instead, it proposes a shift towards stricter liability standards coupled with a ceiling on gatekeeper liability set at a level adequate to deter misconduct, but not to compensate investors. Finally, Part III proposes that the role of a new gatekeeper needs to be recognized and formalized: namely, the attorney who prepares a disclosure document, who should, it argues, be forced to provide a functionally parallel certification with regard to this issuer's non-financial disclosures to the certification provided by the auditor with respect to financial disclosures. The feasibility and scope of such a certification requirement, along with its impact on the attorney's other obligations to its client, are explored in Part III.
Abstract: We explore the role that legal restrictions and path dependence play in determining a country's corporate governance and finance through a case study of institutional investors in the United Kingdom. The U.K. has the same array of institutional investors as the U.S., much looser regulation of these investors, and a strong securities market (much like the U.S.). On the whole, British institutional investors are moderately more active than their U.S. counterparts. They intervene in companies to change management a few times per year. But they are still often passive, absent a crisis, and often prefer to sell their shares rather than press for a change in management or company strategy. Non-legal considerations, including fear that their activism may benefit their institutional rivals, inhibit their desire to participate in corporate governance. If Japan and Germany show how American corporate governance might have developed differently under different legal rules, Britain shows how American corporate governance might look rather similar under more limited regulation.
Abstract: The securities class action cannot be justified in terms of compensation, but only in terms of deterrence. Currently, the damages recovered through private enforcement dwarf the financial penalties levied by public enforcement. Yet, the evidence is clear that corporate officers and insiders rarely contribute to securities class action settlements, with the settlement funds coming instead from the corporation and its insurers. As a result, the cost of such actions in the aggregate falls on largely diversified shareholders. Such a system is akin to punishing the victims of burglary for their negligence in suffering a burglary and does little to deter corporate officials who have private motives for engaging in securities fraud. The present structure of securities class actions benefits a trio of interest groups - corporate officials, plaintiff's attorneys, and insurers - but not shareholders. To reform the securities class action and give it a true deterrent orientation, this article proposes a variety of steps - none requiring legislation or the reversal of well-established precedents - to shift the costs of the securities class action to the culpable. These steps proceed from the twin premises that (1) the settlement of a securities class action is a conflict of interest transaction requiring independent directors to exercise oversight over the allocation process, and (2) enterprise liability is an ineffective approach for misconduct that is privately motivated and easily concealed. To incentivize private enforcers, a basic change in the judicial approach to attorney's fees is proposed.
Abstract: MR. BALOTTI: Good afternoon. My name is Frank Balotti and I've been asked to be the moderator for this afternoon's program. And one of the privileges that I get is to introduce the panel and to call them up to speak in some kind of order, I hope. And I hope that you and the audience will participate by asking questions towards the end of our panel and get involved in the discussion which we hope to promote. The topic for this afternoon's panel is a scholar's approach to corporation law. And we are fortunate to have some scholars with us this afternoon and I refer to the people immediately to my left. Those of you who know the other two way down at the end of my left-hand side will have doubts, of course, about the scholar's approach. But let me introduce first the two scholars who are with us today. First, to my immediate left is Professor John Coffee from Columbia University in that place in New York City where they don't learn very much as we learned from Chancellor Allen a little bit ago. He is the Adolf A. Berle Professor at Columbia. And those of you who watch television know that he is the most televised corporation law professor in the United States. He is frequently quoted both on matters on TV, radio and before Congressional committees and his opinion is often sought by the policymakers of our country. He has served as the reporter for the ALI project on corporate governance. He is the author or co-author of another number of case books and other books for student use. He is the author of too many Law Review articles to mention. And he is a frequent expert witness on corporate matters in courts around the country. Next to Jack Coffee is Rich Booth. Roberta Romano was unable to be with us today. And Rich is going to present a scholar's view in place of Roberta. He is a professor at the University of Maryland School of Law; received his bachelors degree from the University of Michigan and a J.D. from one of those second tier Ivy League law schools, Yale. He spent several years as a litigator at Donovan Leisure and then taught at SMU, Case Western, Chicago Kent. Now teaches business association, securities regulation, corporate finance, business planning at the University of Maryland, where he also serves as the faculty advisor to the Business Lawyer which is now put together by students at the University of Maryland Law School. He is a prolific writer, writes for the popular press such as the Wall Street Journal, New York Times, National Law Journal and also for the serious press. Again, he is the author and co-author of case books and other materials for student use and, like Jack Coffee, the author of many, many law reviews. And next to Rich Booth we have Dave McBride from Young, Conaway, Stargatt & Taylor. Are you a scholar, Dave? MR. McBRIDE: Absolutely not, Frank. MR. BALOTTI: And next to Dave McBride we have Rod Ward ? that's Ed Welch who is going to be here in place of Rod Ward. And Ed, I hope you don't feel like the young aide to Governor Woodrow Wilson who ran into the Governor at 2:00 in the morning one night, woke him up and said, "Governor Wilson, I have bad news for you. The Secretary of Agriculture has died." And the Governor said, "Well, I'm very sorry to hear that. But why are you waking me at 2:00 in the morning to tell me that?" And the young aide said, "Well, Governor, I'd like to take his place." And the governor is reported to have answered, "That's fine by me if it's all right with the undertaker." But Ed will be here to help us by asking some questions of our speakers. He has prepared a long dissertation in the thirty to forty-five seconds notice that he had that he was going to participate. But I look forward to the presentations of our panelists and then hopefully some lively discussion afterwards. And with that, I'd like to turn it over to Rich Booth to lead us off.
Abstract: Section 307 of the Sarbanes-Oxley Act authorizes the SEC to prescribe "minimum standards of professional conduct" for attorneys "appearing or practicing" before it. This brief statutory provision frames a much larger question: What is the role of the corporate attorney in securities transactions in the public markets? Is the attorney's role that of (a) an advocate, (b) a transaction cost engineer, or, more broadly, (c) a gatekeeper - that is, a reputational intermediary with some responsibility to monitor the accuracy of corporate disclosures? The bar has long divided over this question, with the bar associations resisting any such obligation. Yet, Section 307 now "federalizes" this issue. Skeptics of a gatekeeper role for attorneys have long argued that (a) such a role conflicts with the traditional obligations of loyalty that the attorney owe their clients; and (b) imposing gatekeeping obligations on attorneys will chill attorney/client communications and thereby reduce law compliance. Thus, they have resisted a pending SEC proposal that would require an attorney to make a "noisy withdrawal" when the attorney is unable to stop or prevent certain ongoing material violations of law by the corporate client. This comment examines these arguments that attorneys make inferior gatekeepers and replies that (i) securities attorneys can and do perform a "gatekeeping" function; (ii) the differences between attorneys and auditors are less fundamental than bar associations maintain; (iii) in some respects, it is easier to impose gatekeeper obligations on attorneys than on auditors; and (iv) imposing such obligations on attorney should neither chill socially desirable client communications nor reduce the attorney's influence over the client (and probably will increase that leverage). Finally, this comments examines specific standards and obligations that the SEC might adopt to recognize the securities attorney's role as a gatekeeper. Going beyond the narrow "noisy withdrawal" issue, it proposes both limited certification and independence standards.
Abstract: The 2008 financial crisis has necessarily raised the question of regulatory redesign. Were regulatory failures responsible to any significant degree for the insolvency of the major investment banks? Even prior to the crisis's cresting, the Treasury Department issued a Blueprint in early 2008 concluding that the regulation of financial institutions in the U.S. was overly fragmented. This paper analyses both the Treasury Department's proposals and the role of the SEC in the rapid increase of leverage at major investment banks in the 2005 to 2008 era that led to their insolvency. Finding the SEC to be more competent at consumer protection and antifraud enforcement than at prudential financial regulation, this paper supports a twin peaks model for financial regulation in preference to either a universal regulator or the U.S.'s current system of functional regulation. It disagrees, however, with the Treasury's recommendation of greater reliance on self-regulation and principles over rules, finding that deference to self-regulation was at the heart of the SEC's recent failure in the Consolidated Supervised Entity Program and provides a paradigm of when self-regulation will fail. An alternative (and more modest) proposal is also made to Treasury's proposed preemption of state securities regulation. This article will appear in the 75th Anniversary SEC Symposium in the Virginia Law Review.
Abstract: The rules of "litigation governance" in class actions are diametrically different from the rules of corporate governance, in large part because the former works off an "opt out" rule while the latter employs an "opt in" rule. This results in higher agency costs in the former context. To address this problem, reformers have long favored remedies such as the "lead plaintiff" provision of the Private Securities Litigation Reform Act ("PSLRA"), which in theory give class members a stronger voice. Empirically, however, such "voice-based" reforms appear to have had no more than a modest impact. But an alternative remedy appears to be more promising: "exit-based" reforms that seek to provoke greater competition between class counsel and attorneys soliciting class members to opt out of the class and file individual actions with them in state court. Unnoticed by academics, a major trend towards institutional investors opting out of securities class actions has developed over the past five years. More importantly, these opt outs appear to be recovering per share amounts that are a multiple of the class per share recovery. This development poses a variety of issues that this paper examines: (1) Why do opt outs do better?; (2) Do the opt outs gains come at the expense of those who remain in the class?; (3) Can defendants feasibly restrict opt outs and how should courts respond to such attempts?; (4) Are pension funds and other institutional investors under a fiduciary or ERISA-based duty to opt out?; and (5) Will greater competition produce greater accountability?
Abstract: The Supreme Court is about to hear Dura Pharmaceuticals Inc. v. Broudo, a case in which the Ninth Circuit significantly liberalized the "loss causation" standards applicable to federal securities litigation. In response to a companion article by Professor Merritt Fox, which favors such a liberalization and even the abandonment of loss causation as a necessary element, Professor Coffee argues that any change in causation standards that permits a plaintiff to escape showing a decline in the security's stock market price attributable to the material misstatement or omission gives rise to perverse incentives, which would likely result in the award of phantom losses that may have been caused instead by other factors, such as a market bubble. More generally, he argues that the securities class action against the corporate defendant in cases of secondary market stock drops appears to serve little legitimate function, advancing neither compensatory nor deterrent ends. Instead, such actions against the corporation (as opposed to actions against gatekeepers, controlling persons or the corporation in the primary market setting) principally effect inefficient wealth transfers among largely diversified shareholders. Given the legal and other transaction costs involved, shareholders appear likely to be net losers from such actions. As a result, he concludes that further minimization of the causation requirement should await policy clarification of the role of the "fraud on the market" action against a non-trading issuer defendant.
Abstract: This is the congressional testimony of Professor John C. Coffee, Jr., before the United States Senate Committee on Banking, Housing and Urban Affairs.
Abstract: A wave of financial irregularity in the USA in 2001-2 culminated in the Sarbanes-Oxley Act. A worldwide stockmarket bubble burst over this same period, with the actual market decline being proportionately more severe in Europe. Yet, no corresponding wave of financial scandals involving a similar level of companies occurred in Europe. Given the higher level of public and private enforcement in the USA for securities fraud, this contrast seems perplexing. This paper submits that different kinds of scandals characterize different systems of corporate governance. In particular, dispersed ownership systems of governance are prone to the forms of earnings management that erupted in the USA, but concentrated ownership systems are much less vulnerable. Instead, the characteristic scandal in such systems is the appropriation of private benefits of control. This paper suggests that this difference in the likely source of, and motive for, financial misconduct has implications both for the utility of gatekeepers as reputational intermediaries and for design of legal controls to protect public shareholders. The difficulty in achieving auditor independence in a corporation with a controlling shareholder may also imply that minority shareholders in concentrated ownership economies should directly select their own gatekeepers.
Abstract: Both Europe and the United States are rethinking their approach to aggregate litigation. In the United States, class actions have long been organized around an entrepreneurial model that uses economic incentives to align the interest of the class attorney with those of the class. But increasingly, potential class members are preferring exit to voice, suggesting that the advantages of the U.S. model may have been overstated. In contrast, Europe has long resisted the U.S.’s entrepreneurial model, and the contemporary debate in Europe centers on whether certain elements of the U.S. model - namely, opt-out class actions, contingent fees, and the “American rule” on fee shifting - must be adopted in order to assure access to justice. Because legal transplants rarely take, this Essay offers an alternative “non-entrepreneurial model” for aggregate litigation that is consistent with European traditions. Relying less on economic incentives, it seeks to design a representative plaintiff for the class action who would function as a true “gatekeeper,” pledging its reputational capital to assure class members of its loyal performance. Effectively, this model marries aspects of U.S. “public interest” litigation with existing European class action practice. Examining the differences between U.S. and European practice, this Essay argues none of these differences are dispositively prohibitive and that functional substitutes, including an opt-in class action and third party funding, could be engineered so as to yield roughly comparable results. Although the two systems might perform similarly in terms of compensation, the ultimate question, it argues, is the degree to which a jurisdiction wishes to authorize and arm a private attorney general to pursue deterrence for profit.
Abstract: This paper assesses the prospects for meaningful reform of the class action after Amchem Products v. Windsor and Ortiz v. Fibreboard Corp. It reads these decisions as viewing "class cohesion" as the essential rationale that legitimizes representative litigation. Although it agrees that a legitimacy principle must underlie representative litigation, it doubts that "class cohesion" can bear that weight, either as a theory of political representation or as an economic solution for the agency cost and collective action problems in representative litigation. Instead, using the familiar terminology of "exit," "voice" and "loyalty," it suggests that "exit" should prove a superior remedy to voice, and can be implemented through procedures that use exit (much like the appraisal remedy in corporate law) to discipline unfaithful fiduciaries. More generally, it argues that the same accountability mechanisms that work in the field of corporate governance should work in this context as well. Because Amchem and Ortiz may be read to require overly rigorous procedural requirements that could lead to what this article terms the "Balkanization" of the class action, this article further suggests that "exit" should sometimes constitute a functional substitute for "voice" or "loyalty." As a remedy, "exit" can be structured so as to maximize individual choice and promote competition between non-overlapping classes. Thus,the benefits of competition can be realized without increasing the the risk of collusion or a "reverse auction." On the normative level, a choice must be made between viewing the class as an entity and viewing it as an aggregation of individuals. This article argues for the latter view and posits that the basic fiduciary duty of the counsel in representative litigation should be to protect client autonomy.
Abstract: This article begins with an evaluation of the inventory of legal doctrines that courts use to review and regulate control transactions, specifically whether or not these doctrines may be utilized to distinguish efficient from inefficient transactions. Next, the article examines the likelihood of inefficient control transfers, and considers the economic arguments both for and against a proportionate value standard of valuation. The article also addresses the problems of implementation of a proportionate value standard, and considers what proportionate value should mean when the potential for synergy leads insiders to seek to expel the public shareholders. In sum, this article does not seek to challenge the rule that a seller may receive a control premium, but it does seek to focus on whether the legitimacy of the control premium has any necessary corollary for the valuation of minority shares.
Abstract: The appropriate standard to be awarded in buyout and appraisal cases where a controlling shareholder wishes to squeeze-out the minority has occasioned a voluminous debate. In brief, economists have argued against any obligation on the part of the majority group to share prospective synergy gains with the minority on the grounds that this would frustrate efficiency-promoting transactions. Yet, courts in Delaware, New York and elsewhere continue to require such an allocation. This paper focuses on the latest Delaware case law dealing with the rights and obligations of controlling shareholders in the transfer of control context. Although it agrees that an equal opportunity rule would be unwise, it recommends a generalized proportionate value standard coupled with a sharing of synergy gains in the special circumstances where the control buyer had access to asymmetric information.
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