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.

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.

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.

Firms rarely go from solvency to Chapter 11 in an instant. Instead, the slide into bankruptcy will be marked by a period (the “zone of distress”) that begins with the breach of a lending contract and ends, perhaps months or even years later, with either a formal bankruptcy case or some other resolution, such as a nonbankruptcy restructuring or liquidation. In this period, the firm’s governance will be up for grabs. Doctrinally, state corporate law gives directors the power and responsibility to manage the firm for the benefit of shareholders, subject to fiduciary review. In fact, however, real control shifts away from directors and shareholders to creditors. Yet, the law offers little to check this control. Creditors are not generally viewed as fiduciaries, and so they owe their borrowers neither duties of care nor loyalty. In theory, regulation or contract could channel creditor conduct in the zone of distress, but three fundamental changes in the dynamics among distressed firms and their investors have weakened these constraints.