Archives For corporate law

Banning Executives

Josh Wright —  6 July 2011

From the WSJ:

The Department of Health and Human Services this month notified Howard Solomon of Forest Laboratories Inc. that it intends to exclude him from doing business with the federal government. This, in turn, could prevent Forest from selling its drugs to Medicare, Medicaid and the Veterans Administration. If the government implements its ban, Forest would have to dump Mr. Solomon, now 83 years old, in order to protect its corporate revenue. No drug company, large or small, can afford to lose out on sales to the federal government, a major customer.


The Health and Human Services department startled drug makers last year when the agency said it would start invoking a little-used administrative policy under the Social Security Act against pharmaceutical executives. This policy allows officials to bar corporate leaders from health-industry companies doing business with the government, if a drug company is guilty of criminal misconduct. The agency said a chief executive or other leader can be banned even if he or she had no knowledge of a company’s criminal actions. Retaining a banned executive can trigger a company’s exclusion from government business.

Debarment is obviously a very serious remedy.  The increased use of debarment in this context has been controversial, especially in cases in which the executive has not demonstrated that the debarred individual is actually complicit.  The WSJ story discusses the Forest Laboratories example along these lines in more detail:

According to Mr. Westling, “It would be a mistake to see this as solely a health-care industry issue. The use of sanctions such as exclusion and debarment to punish individuals where the government is unable to prove a direct legal or regulatory violation could have wide-ranging impact.” An exclusion penalty could be more costly than a Justice Department prosecution.

He said that the Defense Department and the Environmental Protection Agency, for example, have debarment powers similar to the HHS exclusion authority.

The Forest case has its origins in an investigation into the company’s marketing of its big-selling antidepressants Celexa and Lexapro. Last September, Forest made a plea agreement with the government, under which it is paying $313 million in criminal and civil penalties over sales-related misconduct.

A federal court made the deal final in March. Forest Labs representatives said they were shocked when the intent-to-ban notice was received a few weeks later, because Mr. Solomon wasn’t accused by the government of misconduct.

Forest is sticking by its chief. “No one has ever alleged that Mr. Solomon did anything wrong, and excluding him [from the industry] is unjustified,” said general counsel Herschel Weinstein. “It would also set an extremely troubling precedent that would create uncertainty throughout the industry and discourage regulatory settlements.”

The issue of debarment also arises in the antitrust context as a weapon in the toolkit of antitrust enforcement agencies prosecuting cartels.  Judge Ginsburg and I have argued, in Antitrust Sanctions, that the debarment remedy in that context, along with a shift toward individual responsibility and away from ever-increasing corporate fines, would result in a shift toward efficient deterrence.   In our case, we discuss debarment for the executive actually engaged in the price-fixing as well as officers and directors who negligently supervise the price-fixers (e.g., with failure to institute an antitrust compliance program).   Without safeguards to ensure that debarment is imposed in cases of actual wrongdoing or negligent supervision, and also in the cases of settlement, that there is a factual basis for debarment, imposition of these penalties runs the risk that enforcement agencies will have arbitrary power to banish executives that are disfavored for whatever reason.  If its application is properly constrained, however, debarment can be a more effective tool in prosecuting antitrust offenses and potentially other white-collar crime than ever-increasing corporate fines which are largely borne by shareholders.  I’ll refer interested readers to the Ginsburg & Wright link above for the more detailed case in favor of adding debarment to the cartel-enforcement toolkit, including a discussion of its application in the antitrust context in a variety of other countries as well as non-antitrust settings in the U.S.


In a recent Dealbook post, Steven M. Davidoff complains that Delaware’s business judgment rule is too lenient.  Davidoff contends that “[a] Delaware court is not going to find [directors] liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.”  He then asserts that a commonly heard justification for this lenient approach — that it is required in order to induce qualified individuals to serve as directors — is “laughable.”

Prof. Davidoff’s pithy summary of the Delaware business judgment rule seems accurate, and I share his skepticism toward the argument that the rule is justified as a means of inducing highly qualified directors to serve.  I disagree, though, with his insinuation that the Delaware approach is unjustified.  The rule makes a great deal of sense as a means of aligning the incentives of directors (and officers) with those of shareholders.

Under Delaware’s business judgment rule, courts will abstain from second-guessing the merits of a business decision — even one that appears, in retrospect, to have been substantively unreasonable — as long as the directors acted honestly, in good faith, without any conflict of interest, and on a reasonably informed basis (i.e., they weren’t “grossly negligent” in informing themselves prior to making the decision at issue).  Courts treat the rule as quasi-jurisdictional, insisting that they simply will not hear complaints about the substantive reasonableness of a decision as long as the prerequisites to BJR protection are satisfied. 

One frequently hears two justifications for this deferential approach.  First, courts sometimes seek to justify it on grounds that they are not business experts.  Second, as Prof. Davidoff observes, directors and officers often defend it on grounds that it’s needed to prevent qualified directors from being scared off by the prospect of huge liability for good faith business decisions that turn out poorly.  

Neither justification works very well.  Courts routinely second-guess the substance of decisions in areas where they lack expertise and might, by imposing liability, dissuade qualified individuals from offering their services.  Consider, for example, medical malpractice.  Courts aren’t medical experts, yet they routinely second-guess the substance of good faith, reasonably informed treatment decisions.  And they do this with full knowledge that malpractice judgments dissuade qualified doctors from providing their services.  (Remember President Bush’s concern that malpractice verdicts were dissuading gynecologists from “practic[ing] their love with women all across this country”?)  There must be something more to the story.

Indeed, there is.  By insulating directors from liability for good faith, informed business decisions that turn out poorly, the business judgment rule encourages directors to take greater business risks.  This is a good thing, because directors and officers tend to be more risk averse than their principals, the shareholders.  I previously explained that point in criticizing Mark Cuban’s claim that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.”  I wrote:

… Stockholders would normally prefer corporate managers to take more, not less, business risk.

When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). …

Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.

The need to reconcile risk preferences among corporate managers (directors and officers) and their principals (the shareholders) provides a compelling justification for Delaware’s business judgment rule.  Chancellor Allen clearly articulated this point in footnote 18 of the 1996 Caremark opinion:

Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical “reasonable person”, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what persons of ordinary or average judgment and average risk assessment talent regard as “prudent” “sensible” or even “rational”, such persons will have a strong incentive at the margin to authorize less risky investment projects.

As Geoff has often reminded us, the optimal level of business risk is not zero.

Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

Stephen Bainbridge is the William D. Warren Professor of Law at UCLA School of Law.

Mandatory disclosure is a—maybe the—defining characteristic of U.S. securities regulation. Issuers selling securities in a public offering must file a registration statement with the SEC containing detailed disclosures, and thereafter comply with the periodic disclosure regime. Although the New Deal-era Congresses that adopted the securities laws thought mandated disclosure was an essential element of securities reform, the mandatory disclosure regime has proven highly controversial among legal academics—especially among law and economics-minded scholars. Some scholars argue market forces will produce optimal levels of disclosure in a regime of voluntary disclosure, while others argue that various market failures necessitate mandatory disclosure.

Both sides in this longstanding debate assume that market actors rationally pursue wealth maximization goals. In contrast, my work in this area draws on the emergent behavioral economics literature to ask whether systematic departures from rationality might result in a capital market failure necessitating government regulation. I conclude that behavioral economics is a very useful tool, but that it in this instance it cannot fairly be used to justify the system of mandatory disclosure.

Continue Reading…

As I noted last week I participated with several corporate law luminaries in a conference at Western New England College in Springfield, Massachusetts on the famous case of Wilkes v. Springside Nursing Home, 370 Mass. 842, 353 N.E.2d 657 (1976). Springfield is near Pittsfield, where Springside was located and this case originated.

As most law students and corporate scholars know, Wilkes importantly qualified the same court’s case of the year before, Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (1975).  Donahue held that “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.”

The Wilkes court was

concerned that untempered application of the strict good faith standard enunciated in Donahue to cases such as the one before us will result in the imposition of limitations on legitimate action by the controlling group in a close corporation which will unduly hamper its effectiveness in managing the corporation in the best interests of all concerned. The majority, concededly, have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority. * * *

Therefore, when minority stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty owed to them by the majority, we must carefully analyze the action taken by the controlling stockholders in the individual case. It must be asked whether the controlling group can demonstrate a legitimate business purpose for its action. * * * In asking this question, we acknowedge the fact that the controlling group in a close corporation must have some room to maneuver in establishing the business policy of the corporation. It must have a large measure of discretion, for example, in declaring or withholding dividends, deciding whether to merge or consolidate, establishing the salaries of corporate officers, dismissing directors with or without cause, and hiring and firing corporate employees.

When an asserted business purpose for their action is advanced by the majority, however, we think it is open to minority stockholders to demonstrate that the same legitimate objective could have been achieved through an alternativecourse of action less harmful to the minority’s interest. * * *

The court held that the defendants had not shown a legitimate business purpose for firing plaintiff and minority shareholder Wilkes, and therefore that the action was an illegitimate freeze-out, entitling Wilkes to a remedy.

The conference featured an interesting discussion between the lawyers who represented Wilkes and Springside.   We learned from Wilkes’s lawyer (and nephew) David Martel how his senior lawyer on the case, James Egan, fashioned a case for breach of a partnership agreement despite the fact that the parties had incorporated because Egan knew about case law where shareholders were treated as partners.

The master and probate court rejected the partnership theory below because the parties had incorporated. The highest court took the case on direct appeal. That court had just decided Donahue and evidently was looking for an opportunity to refine the rule in Donahue. (Yet based on my inquiries at the conference, it’s not clear Mr. Egan even knew about Donahue when he fashioned his partnership argument.)

Retired Judge William Simons, Springside’s lawyer, described the parties deal as one to buy and sell property.  Simons says the facts didn’t support the theory that the parties were “truly a partnership” and thought the Supreme Judicial Court should have ordered another hearing rather than taking this as an established fact.

I find the following quotes from the Wilkes opinion particularly significant:

Wilkes consulted his attorney, who advised him that if the four men were to operate the contemplated nursing home as planned, they would be partners and would be liable for any debts incurred by the partnership and by each other. On the attorney’s suggestion, and after consultation among themselves, ownership of the property was vested in Springside, a corporation organized under Massachusetts law. * * *

In light of the theory underlying this claim, we do not consider it vital to our approach to this case whether the claim is governed by partnership law or the law applicable to business corporations. This is so because, as all the parties agree, Springside was at all times relevant to this action, a close corporation as we have recently defined such an entity in Donahue v. Rodd Electrotype Co. of New England, Inc. * * *

This quote encapsulates the problem in the case:  At the time of Wilkes, the parties had to force what was essentially a partnership into corporate form in order to get the limited liability that would be essential for a venture like a nursing home.  There was no way in 1976 for the parties to have a true partnership with limited liability.  If it had been a partnership, Wilkes could have gotten the firm dissolved for having been denied the participation in governance he was entitled to under partnership law (see Bromberg & Ribstein on Partnership, §7.06(c)).  Without an applicable standard form, and given the costs and difficulties of small firms contracting over exit, the court had to essentially make up a deal for the party ex post. 

My paper for the conference describes how the modern contracting technology enabled by the advent of the LLC (see also The Rise of the Uncorporation) enables a solution of this problem, and therefore assists entrepreneurs like the men involved in Springside Nursing. 

Wilkes and the interesting background we learned in Springfield, Massachusetts provided a glimpse into the past and insight into the future of business associations.

My paper will appear shortly on SSRN and then in the conference issue of the Western New England Law Review. I highly recommend the other papers in the conference, which presented other perspectives on the case.  I may write about some of those papers when they go public.

Last month I noted that the Senate was about to repeat its SOX mistake with another ill-fated foray into regulating corporate governance.  I focused on provisions for mandatory majority voting, separation of the board chair and CEO jobs, risk committees, say-on-pay, and pay-performance disclosures.  

Now Annette Nazareth summarizes (HT Bainbridge) the provisions in the bill that passed the Senate and awaits reconciliation. She notes that the bill “would federalize significant governance and executive compensation matters that have historically been a matter of state law.” Alas, the Senate never voted on an amendment proposed by Delaware’s Carper that would have eliminated (D-Del) that would have eliminated the majority voting provision and a provision for proxy access.

Although none of the provisions Nazareth discusses is individually earth-shaking, they cumulatively touch many major aspects of corporate governance formerly left to contract and state law.  This bill thus clearly adds to the framework for federal takeover of internal governance that SOX established. The overall effect is that it will be increasingly difficult to demark an area left exclusively for state law. This leaves little “firebreak” to protect against judicial incursions in the spaces not yet covered by explicit federal provisions.  This could ultimately profoundly affect the relationship between federal and state law regarding business associations. 

A generation ago the Supreme Court could say that “no principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations, including the authority to define the voting rights of shareholders.” CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69, 89 (1987). 

Erin O’Hara and I have argued that this separation between federal and state spheres does and should affect the scope of implied preemption of state law by federal statutes.  Thus, when the Court held that state securities actions were preempted by the Securities Litigation Uniform Standards Act, it emphasized “[t]he magnitude of the federal interest in protecting the integrity and efficient operation of the market for nationally traded securities.” Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 78 (2006). See also my article on Dabit. However, we noted that “[m]any federal ‘securities’ laws reach deep into the kind of internal governance issues covered by the [internal affairs doctrine].” Thus, corporate internal affairs are only “relatively safe from federal preemption” and internal affairs is not “a constitutional boundary, as shown by the continuing forward march of federal corporation law.”

Under the Dodd bill, the forward march picks up the pace.  

Yet from a policy standpoint the march is very much backward. In my April post I observed that “[a]s financial markets have become far deeper and more competitive since the 30s, it makes little sense for regulators to actually trust them less.” Thus, the Senate has ignored not only the lessons of SOX but the developments in corporate governance and markets that make its governance provisions less necessary than ever.

I’m delighted to report that the Liberty Fund has produced a three-volume collection of my dad’s oeuvre.  Fred McChesney edits, Jon Macey writes a new biography and Henry Butler, Steve Bainbridge and Jon Macey write introductions.  The collection can be ordered here.

Here’s the description:

As the founder of the Center for Law and Economics at George Mason University and dean emeritus of the George Mason School of Law, Henry G. Manne is one of the founding scholars of law and economics as a discipline. This three-volume collection includes articles, reviews, and books from more than four decades, featuring Wall Street in Transition, which redefined the commonly held view of the corporate firm.

Volume 1, The Economics of Corporations and Corporate Law, includes Manne’s seminal writings on corporate law and his landmark blend of economics and law that is today accepted as a standard discipline, showing how Manne developed a comprehensive theory of the modern corporation that has provided a framework for legal, economic, and financial analysis of the corporate firm.

Volume 2, Insider Trading, uses Manne’s ground-breaking Insider Trading and the Stock Market as a framework for many of Manne’s innovative contributions to the field, as well as a fresh context for understanding the complex world of corporate law and securities regulation.

Volume 3, Liberty and Freedom in the Economic Ordering of Society, includes selections exploring Manne’s thoughts on corporate social responsibility, on the regulation of capital markets and securities offerings, especially as examined in Wall Street in Transition, on the role of the modern university, and on the relationship among law, regulation, and the free market.

Manne’s most auspicious work in corporate law began with the two pieces from the Columbia Law Review that appear in volume 1, says general editor Fred S. McChesney. Editor Henry Butler adds: “Henry Manne was an innovator challenging the very foundations of the current learning.” “The ‘Higher Criticism’ of the Modern Corporation” was Manne’s first attempt at refuting the all too common notion that corporations were merely devices that allowed managers to plunder shareholders. Manne saw that such a view of corporations was inconsistent with the basic economic assumption that individuals either understand or soon will understand the costs and benefits of their own situations and that they respond according to rational self-interest.

My dad tells me the sample copies have arrived at his house, and I expect my review copy any day now.  But I can already tell you that the content is excellent.  Now-under-cited-but-essential-nonetheless corporate law classics like Some Theoretical Aspects of Share Voting and Our Two Corporation Systems: Law and Economics (two of his best, IMHO) should get some new life.  Among his non-corporations works, the classic and fun Parable of the Parking Lots (showing a humorous side of Henry that unfortunately rarely comes through in the innumerable joke emails he passes along to those of us lucky enough to be on “the list”) and the truly-excellent The Political Economy of Modern Universities (an updating of which forms a large part of a long-unfinished manuscript by my dad and me) are standouts.  And the content in the third volume from Wall Street in Transition has particular relevance today, and we would all do well to re-learn the lessons of those important contributions.

The full table of contents is below the fold.  Get it while it’s hot! Continue Reading…

Today’s Wall Street Journal includes a terrific article explaining why insider trading should be deregulated. Following up on last week’s high-profile insider trading charges, George Mason economist Don Boudreaux, whose Cafe Hayek posts are essential reading, succinctly sets forth the deregulatory position (which was first and most famously articulated by Geoff’s dad, Henry Manne). Boudreaux explains that:

1. Insider trading leads to a more efficient allocation of capital by ensuring that stocks are accurately priced.

2. Insider trading protects investors against stock mispricing (a la Enron), which ultimately corrects itself and can cause huge investor losses. (On this point, Boudreaux quotes the senior Manne’s comments from a radio interview:

I don’t think the scandals [such as those at Enron and Global Crossing] would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn’t resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have.

I made a similar point in this article.)

3. Insider trading encourages investors to diversify, which is generally a good investment strategy and will lead to fewer wipe-outs (and their accompanying social stresses).

4. The ban on insider trading can reach only decisions to trade on the basis of material non-public information, not undetectable decisions to refrain from trades one otherwise would have made. As Boudreaux explains:

This bias is not only a source of prosecutorial unfairness; its existence casts doubt on the assumption that insider trading is so harmful that it must be treated as a criminal offense. After all, if capital markets continue to function as well as they do given that many investment decisions potentially influenced by inside information are unstoppable because they are undetectable, why believe that the detectable portion of investment decisions influenced by inside information would be harmful if they were legal?

5. Insider trading may, in fact, harm a company’s business by, for example, thwarting a value-enhancing transaction that otherwise would have occurred. The classic historical example is the insider trading in the Texas Gulf Sulphur case, where the company had discovered a valuable ore deposit and was trying to buy up land around the deposit at favorable prices. Insider purchases of TGS stock and call options drove up the price of TGS stock, tipped off neighboring landowners that they should demand a higher price for their property, and thereby harmed the corporate enterprise.

6. Corporations can protect themselves (and their investors) against harmful trading on the basis of material non-public information by creating their own insider trading policies.

7. Capital market pressures will lead corporations to adopt insider trading rules that maximize the value of the enterprise and thus provide the best possible outcome for investors. Corporations themselves, responding to the specific conditions of the capital and labor markets in which they participate (I mention labor markets because the ability to engage in insider trading can be an element of one’s compensation), are more likely than centralized regulators to achieve a value-maximizing policy.

Boudreaux has mastered the art of saying a lot, very clearly, in a small number of words. His article is terrific weekend reading.

TOTM is very pleased to announce a new permanent member, J.W. Verret (George Mason).  J.W. has been blogging at Volokh Conspiracy recently, but he’s been a guest over at The Conglomerate, and the Harvard Law School Corporate Governance Blog.  Quite frankly, it would be difficult to miss him if you’ve been following the recent events in the world of financial regulation.  Professor Verret has been talking about financial regulation and corporate law every where from The NewsHour with Jim Lehrey, to CNN Money,, The American Lawyer, Forbes, and of course, testimony before various House and Senate Committees regarding the Obama Administration’s 2009 financial regulatory reform proposals.

J.W. received his JD and MA in Public Policy from Harvard Law School (where he was an Olin Fellow under Lucian Bebchuk) and the Harvard Kennedy School of Government, respectively, in 2006.  Professor Verret then served as a law clerk for Vice-Chancellor John W. Noble of the Delaware Court of Chancery. Prior to joining the faculty at Mason Law, Professor Verret was an associate in the SEC Enforcement Defense Practice Group at Skadden, Arps in Washington, D.C. He has written extensively on corporate law topics, including a recent paper, Delaware’s Guidance, co-written with Chief Justice Myron T. Steele of the Delaware Supreme Court. His academic work has been featured in the Yale Journal on Regulation, The Business Lawyer, the Delaware Journal of Corporate Law, the University of Pennsylvania Journal of Business Law, and the Virginia Law and Business Review. Professor Verret was recently selected by the Northwestern Law School Searle Center on Law, Regulation, and Economic Growth for a 2009-2010 Searle-Kaufmann Research Fellowship.

J.W. will be finishing up his stint as a visitor at Volokh this week, but we’re happy to give him a permanent blogging home here at TOTM thereafter.

Between the various power grabs and dubious regulatory proposals (each more dubious than the last!) from the likes of Geithner, Bernanke, Frank (.pdf), Dodd, etc., etc. you’d be excused for thinking the financial news from Washington (remember when financial news used to come from New York?) was all bad and growing only worse.

But there is a bright spot in this sad state of affairs:  SEC Commissioner Troy Paredes.  Appointed shortly before Bush left office (with one hand he gave us Troy Paredes; with the other he gave us import duties on Roquefort cheese. I leave it to you to assess the net), Troy is a once and presumably future law professor, treatise author, and all-around sound thinker on issues of corporate governance, corporate law and securities regulation.

Troy has voted against the SEC’s misguided proxy access proposal (see his official comments on the topic here), and he has made impassioned speeches evidencing an otherwise absent understanding of basic corporate governance explaining why the proposal (and others in the same vein) are problematic.  Fundamental to his approach are an understanding of  the role of risk, a humility born of his appreciation for the complexity of markets, and a constant emphasis on data and evidence-based regulation.

For example, here are some essential points from an excellent speech on the overall regulatory response to the crisis. You’ll never here the likes of Barney Frank, Tim Geithner or Larry Summers (the government incarnation) saying these things:

My basic point is this: Even in times of crisis and hardship, when the benefits of regulation seem apparent and there is pressure to “do something,” we cannot overlook the risk of overregulating. It is essential for the government to retain a healthy respect for the role of markets; and we must appreciate that there are limits to what we can and should expect from regulation.

* * *

Regulating to avoid excessive risk is not costless, whatever the benefits may be of securing the financial system and protecting investors and others from misfortune. Some risks simply are worth it if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. In other instances, efforts to clamp down on certain practices and activities may have unintended adverse effects, some of which could exacerbate the concern the regulation targets. This includes the prospect that government action may foster moral hazard. When properly framed, then, the regulatory objective should be to achieve the optimal degree of risk, not necessarily to minimize risk. Achieving the optimal degree of risk involves making tough tradeoffs, netting costs against benefits.

* * *

But I am more troubled by “how” systemic risk might be regulated. Identifying a market failure does not necessarily tell us what the appropriate government response should be. Even when there is a market breakdown, it remains possible for the government’s response to do more harm than good.

* * *

My principal concern turns on the potential scope of the systemic risk regulator’s authority. As a threshold matter, I still have not heard a satisfying definition of what constitutes a systemic risk. Systemic risk is easy enough to conceptualize in theory, but it is much more difficult to identify in practice. What does it mean for a firm to be “too big” or “too interconnected” to fail? A sort of “I know it when I see it” approach to regulating systemic risk is untenable. Such open-endedness accords the regulator too much discretion and is too unpredictable.

Moreover, Troy has made a basic, fundamental argument that I have heard from literally no one else in Washington in all of the debates surrounding executive compensation:  While managers may take on too much risk, they also may take on too little (an argument I have also recently made here):

In large part, the disclosure amendments respond to the potential that companies will take excessive risks. As regulatory reforms are proposed to address excessive risk taking, it is important not to overlook that just as a company can assume too much risk, a company also can be overly cautious. Placing undue emphasis on mitigating downside risk can be costly if it chills enterprises from taking the kind of prudent business risks that drive competition, innovation, and entrepreneurism. Our dynamic economy — marked by a constant stream of cutting-edge goods and services and an ever-expanding set of opportunities — depends on the willingness of individuals to take risks.

Most recently he has spoken about the impending Jones v. Harris case in the Supreme Court (on which see this essential post by Josh), and made some sensible remarks concerning the risks of intrusion (by courts as well as regulators) into well-functioning (and, to be fair, already-regulated) market transactions:

First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly the adviser/board fee negotiations is mitigated.

Second, courts are not well-positioned to second-guess the business decisions that boards and others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board’s decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.

Of course I would be more strident and incautious in my remarks, but then I am not a public official with a need to ensure I don’t marginalize myself (a fact that may be endogenous to my stridency and recklessness, come to think of it).

There is more from Troy (find his speeches and statements here (scroll down)), and I expect we will see much more to come.  I know that there are many of us in the legal and academic communities who welcome these views, and I hope we will do whatever we can to ensure that they gain as much currency as possible.  I harbor no illusions about Troy’s ability to redirect Barney Frank’s steamroller, but I am delighted that he is out there, at the highest ranks of the government, fighting the good fight.

I have been asked a few times today to opine, as a corporate and securities law scholar, on President Obama’s nomination of Judge Sonia Sotomayor for the Supreme Court.  ( has a couple of quotes reflecting my thoughts.)

I have three main comments:

First, this is a pivotal time in American securities and corporate law jurisprudence.  Any appointment to the Supreme Court has the potential to significantly influence the evolution of corporate and securities law.  The Supreme Court has recently granted certiorari for a couple of big-ticket securities and corporate law cases, and there is every reason to believe, particularly in light of the SEC’s recently announced rulemaking and Senator Schumer’s recently proposed Shareholder Bill of Rights Act of 2009, that the Supreme Court will continue to handle important business matters like these in the near future.  Federal preemption, Securities and Exchange Commission rule-making authority, corporate governance reform, damages, and the reach of federal securities laws are all incredibly important topics that are certain to come before the Supreme Court in the next few terms.

Second, it is difficult to gauge where exactly Judge Sotomayor falls on the spectrum of pro-management versus pro-investor jurists.  Is she a shareholder primacist, does she defer to the invisible hand of the market, does she interpret Section 10(b) of the Securities Exchange of 1934 broadly or narrowly?  These are questions to which Judge Sotomayor’s judicial writings provide no clear answers.  Sotomayor was nominated to the federal bench by President Bush, so one might have suspected that she would embrace ardent pro-management leanings.  However, the business and securities opinions she has penned have not evinced such a bent.  For example, she penned the Second Circuit’s relatively recent shareholder-friendly opinion in Merrill Lynch v. Dabit (a detailed summary of the case is available here).  Indeed, upon reflection, one recalls that Sotomayor was viewed as a less conservative Bush nominee (proposed by Moynihan) when she was appointed, and it was President Clinton who elevated her to the Second Circuit.  Yet Judge Sotomayor has dismissed numerous cases in favor of management despite her more liberal affiliations.

Third, Judge Sotomayor has a strong background in sophisticated corporate and securities law cases, as she comes from the Second Circuit, a jurisdiction that generates a significant number of these cases (given that Wall Street falls within the jurisdiction of the Second Circuit).  This bodes well, in that pundits often query whether Supreme Court jurists fully appreciate the complex business nuances arising in many securities and corporate matters.  That Judge Sotomayor has been both a district court judge and an appellate judge in a jurisdiction where these difficult business cases arise delights me, and I think she would add a valuable perspective on the Supreme Court.

Taking off the “corporate and securities law scholar” hat, and putting on the “Chair of the American Association of Law Schools Section on Women in Legal Education” hat, I can say that I am thrilled that President Obama has nominated a woman to the Supreme Court.  I was disheartened that Justice O’Connor’s seat was not filled by a woman, but I remain optimistic that someday the number of women on the Supreme Court will mirror, as a percentage, the number of women in the average law school entering class.

Of course, given that, in the almost 30 years since a woman first ascended to the United States Supreme Court, we appear to have reached a plateau, with only two women serving at any one time over the past 16 years, perhaps my optimism is misplaced.  I remain optimistic nevertheless.

The Law Market

Josh Wright —  6 January 2009

The Law Market, Larry Ribstein’s new and important book with Erin O’Hara looks great and is available here from Oxford University Press.  The book description from the website sets the stage:

Today, a California resident can incorporate her shipping business in Delaware, register her ships in Panama, hire her employees from Hong Kong, place her earnings in an asset-protection trust formed in the Cayman Islands, and enter into a same-sex marriage in Massachusetts or Canada–all the while enjoying the California sunshine and potentially avoiding many facets of the state’s laws.
In this book, Erin O’Hara and Larry E. Ribstein explore a new perspective on law, viewing it as a product for which people and firms can shop, regardless of geographic borders. The authors consider the structure and operation of the market this creates, the economic, legal, and political forces influencing it, and the arguments for and against a robust market for law. Through jurisdictional competition, law markets promise to improve our laws and, by establishing certainty, streamline the operation of the legal system. But the law market also limits governments’ ability to enforce regulations and protect citizens from harmful activities. Given this tradeoff, O’Hara and Ribstein argue that simple contractual choice-of-law rules can help maximize the benefits of the law market while tempering its social costs. They extend their insights to a wide variety of legal problems, including corporate governance, securities, franchise, trust, property, marriage, living will, surrogacy, and general contract regulations. The Law Market is a wide-ranging and novel analysis for all lawyers, policymakers, legislators, and businesses who need to understand the changing role of law in an increasingly mobile world.