Three scandals have reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “ABACUS” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together—a deal structure known as the synthetic collateralized debt obligation involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through preset instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real-world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
You are approached by a dear friend who says, “I have a terrific business concept—diamond mining in Siberia. Just a pickaxe, divining rod, and some elbow grease. It’s going to be terrific. The problem is, I need a little bit of cash to get it off the ground. Any interest? I can offer you a share of the company.” Although you know little about Siberia or investing, you decide to invest. He sends you a sixty-five-page LLC operating agreement for Sub-Zero Mining, LLC (“it’s mostly boilerplate”), which you review briefly and sign. You send it back to him, along with a check for your investment.
Six months later, having heard nothing from your friend, you run into him, and he is driving a brand-new sports car. You ask him, “How did the mining in Siberia go?”
“It was terrific,” your friend explains. “I have more money than I know what to do with!”
Naturally, you ask for your share.
U.S. regulation of public investment companies (such as mutual funds) is based on a notion that, from a governance perspective, investment companies are simply another type of business enterprise, not substantially different from companies that produce goods or provide (noninvestment) services. In other words, investment company regulation is founded on what this Article calls a “corporate governance paradigm,” in that it provides a significant regulatory role for boards of directors, as the traditional governance mechanism in business enterprises, and is “entity centric,” focusing on intraentity relationships to the exclusion of super-entity ones. This Article argues that corporate governance norms, which came to dominate U.S. investment company regulation as a result of the unique history of U.S. investment companies, are poorly-suited to achieve the goals of investment company regulation. In particular, the corporate governance paradigm has given rise to a number of regulatory weaknesses, which stem from investment advisers’ effective control over investment company boards of directors and courts’ deference to state corporate law doctrine in addressing investors’ grievances. Accordingly, investment company regulation should acknowledge that investment companies are not merely another type of business enterprise with the same challenges and tensions arising from the separation of ownership and control that appear in the traditional corporate context. Toward that end, this Article contends that policymakers should view, and regulate, investment companies as an avenue through which investment advisers provide financial services (investment-advisory services, in particular) to investors–and should view investment company shareholders more as advisory customers than as equity owners of a firm. This “financial services” model of regulation moves past the entity focus of corporate governance norms and, therefore, permits dispensing with governance by an “independent” body such as the board of directors. More importantly, if adopted, this model would remedy some of the more significant problems plaguing U.S. investment company regulation.
In the early months of the financial crisis that started in August 2007, Citigroup suddenly had to take onto its balance sheet $25 billion of assets–which, due to subprime mortgage exposure, were worth on the market only a third the amount that Citigroup was required to pay for them. The reason for the appearance of these troubled assets on the bank’s balance sheet was a liquidity guarantee provided by Citibank from the time it originally sold the assets to protect short-term lenders from the possibility that their debt could not be refinanced at maturity. The Financial Crisis Inquiry Commission would conclude that such guarantees helped “bring the huge financial conglomerate to the brink of failure.”
The assets in question were collateralized debt obligations (“CDOs”), which package together a large number of loans and other debt products and use the income from those loans to pay returns to the investors in the CDOs. It is clear, however, that not all of the “loans” underlying Citibank’s CDOs were actual loans. Some of them were financial contracts called derivatives that promised payments based on the performance of a specific set of actual loans. That is, some of the underlying assets were not loans, but simply represented the promise of one financial institution to make payments to another.
It is easier to invest in the stock market now than it has ever been. With the proliferation of the Internet, online investing websites have nearly obliterated the need for stockbrokers and have given individuals the ability to invest in whatever they choose — for around seven dollars per trade, a person can own a share of almost any publicly traded company. While this is certainly a step forward for the world of investing, it does not come without risk. Relying solely on personal research and investing knowledge can lead to an undiversified portfolio and a lot of uncompensated risk. Investors learned this the hard way when the market began to fall in 2007. As a result, many young investors have become shell-shocked and wary of investing in the stock market. According to the Investment Company Institute, in 2005, 48 percent of people under age thirty-five said they were “willing to take substantial or above-average risks in their portfolios”–that number at the start of 2011 had fallen to 34 percent.
It is not necessary, however, to rely solely on one’s own investing prowess when trying to navigate the stock market. Trained professionals offer their services in many forms–almost always for a price. Mutual funds represent one of the most significant ways in which trained professionals are involved with the investment decisions of others. “A mutual fund is a pool of assets, consisting primarily of [a] portfolio [of] securities, and belonging to the individual investors holding shares in the fund.” In 2009, 43 percent of all households in the United States owned mutual funds, with an estimated total of 51,200,000 households invested in mutual funds. The total amount of assets in mutual funds in 2009 was over eleven trillion dollars. Clearly, many people rely on the abilities of mutual fund managers to guide their investment decisions. By purchasing shares in mutual funds, people can own shares of portfolios that are as diversified as they desire without having to pick investments on their own.
History has shown that the scholarly and regulatory focus on board composition and structure is a dangerously incomplete solution to the problems that have caused recent corporate failures. The media and corporate scholars have assigned much of the blame for the 2008 financial crisis and the Enron-era corporate scandals to corporate boards. The conventional diagnosis of these ills is that boards were largely at fault because they failed to effectively monitor corporate officers. Unfortunately the conventional diagnosis of the problem is incomplete and the policy prescriptions flowing from this faulty diagnosis are unlikely to address the very real problems that continue to plague corporate governance.
The principal problem is that most regulatory attempts fail to adequately consider an essential step in understanding the board’s relationship to corporate failure: the process by which boards monitor corporate performance. By relying on insights from a robust organization behavior literature, this Article demonstrates that the processes boards employ to undertake their monitoring function are in need of significant improvement. In other words, how boards engage in management monitoring should be the focus of corporate regulatory reform, more so than who sits on boards or how boards are structured.
The law of exclusionary vertical restraints–contractual or other business relationships between vertically related firms–is deeply confused and inconsistent in both the United States and the European Union. A variety of vertical practices, including predatory pricing, tying, exclusive dealing, price discrimination, and bundling, are treated very differently based on formalistic distinctions that bear no relationship to the practices’ exclusionary potential. We propose a comprehensive, unified test for all exclusionary vertical restraints that centers on two factors: foreclosure and substantiality. We then assign economic content to these factors. A restraint forecloses if it denies equally efficient rivals a reasonable opportunity to make a sale or purchase (depending on whether the restraint affects access to customers or inputs). Market foreclosure is substantial if it denies rivals a reasonable opportunity to reach minimum viable scale. When substantial foreclosure is shown, the restraint should generally be declared illegal unless it is justified by efficiencies that exceed the restraint’s anticompetitive effects.
Consumer contracts are pervasive. Yet, the promises that make up these contracts are becoming increasingly empty, as sellers reserve the power to modify their contracts unilaterally. While some modifications benefit both sellers and consumers, others increase seller profits at the consumer’s expense. The law’s goal should be to facilitate good modifications, while preventing bad ones. Currently this goal is not met. The problem is twofold. First, consumers fail to appreciate the risk of unilateral modification and thus fail to demand a commitment by sellers to avoid inefficient modifications. Second, and more important, even if consumers demand a commitment to make only mutually beneficial modifications, existing commitment mechanisms—consumer assent to modifications, judicial review of modifications, and seller reputation—are inadequate. We propose a novel commitment mechanism: adding Change Approval Boards (“CABs”) as parties to consumer contracts. These CABs would selectively assent to, or withhold assent from, contractual changes that sellers wish to make, according to each CAB’s modification policy. We envision a market for CABs—multiple CABs, each striking a different balance between flexibility and security, offering a range of modification policies from which consumers can choose. The market-based CAB system promises to deter abusive term changes while retaining the flexibility to change consumer contracts when change is justified.
Many people believe that excessive risk taking at large financial firms was an important cause of the financial crisis of 2007–2008 and that preventing another crisis requires improving risk-management systems at such institutions. One way to do this would be to use board oversight liability to hold directors personally liable for failing to properly monitor the risks that their firms are running. The purpose of this Article is to determine what role director oversight liability can efficiently play in improving risk-management practices at large financial firms.
A key contention of this Article is that previous treatments of this problem have largely failed to appreciate what risk managers at large financial firms actually do, and so the Article begins by explaining some of the financial models that risk managers typically use to measure the market risk and credit risk on portfolios of assets. A realistic appreciation of these models shows that the measurements of risk that they yield must necessarily incorporate paradigmatic business judgments, most importantly because these models aim to predict future results on the basis of historical data. In other words, the predictive ability of the models is founded on the business judgment that the future will resemble the past in relevant respects. Risk-management decisions are therefore always business decisions.
Historically, there existed two main fiduciary duties in corporate law, care and loyalty, and only violations of the duty of loyalty were likely to lead to liability. In the 1980s and 1990s, the Delaware Supreme Court breathed life into the duty of care, created a number of intermediate standards of review, elevated the duty of good faith to equal standing with care and loyalty, and announced a unified test for review of breaches of fiduciary duty. The law, which once seemed so straightforward, suddenly became elaborate and complex. In 2006, in the case of Stone v. Ritter, the Delaware Supreme Court rejected the triadic formulation and declared that good faith was a component of the duty of loyalty. In this and other respects, Delaware seems to be returning to a bifurcated understanding of the law of fiduciary duties. I believe that this is a mistake. This area of law is inherently complex and much too important to be oversimplified.
The current academic debate on the issue focuses on whether there should be two duties or three. In this Article, I argue that the question is misleading and irrelevant, but that if it must be asked, the best answer is that there are five duties—one for each paradigm of enforcement. In defending this claim, I explain the true nature of fiduciary duties and provide a robust framework for the discussion, implementation, and development of the law.