The fall of 2007 heralded a tumultuous time in the U.S. capital markets. The implosion of the subprime mortgage market disrupted the economy and caused the credit markets to dry up and become increasingly illiquid. Almost overnight, credit became both more expensive and more difficult to obtain as financial institutions became unwilling to extend financing. The credit securitization market was particularly affected, leaving many financial institutions with pending and existing loans that they could only securitize and sell, if at all, at a large loss. Faced with these potentially large losses, financial institutions began to balk at funding preagreed private equity acquisitions. This sudden, unexpected turn of events and the general revaluation and decline in stock prices it wrought led private equity firms to reassess their pending acquisitions—acquisitions which had been agreed to in more stable times. The private equity firms’ reevaluations were often unkind. Throughout the fall and into 2008, private equity firms repeatedly attempted to terminate their contractual obligations to acquire companies.
The material adverse change (“MAC”) clause is a contract provision that periodically dominates the headlines, usually in the wake of a major financial downturn, and the most recent downturn has not been an exception. A MAC clause dispute typically occurs when one side of an agreement no longer wants to complete a merger or acquisition, and often the stakes are high: in the midst of the credit crisis and economic turmoil that began in 2007, MAC disputes erupted in at least thirteen high-profile transactions—the four largest disputes ranging from $1.5 billion to $25.3 billion. As recently as fifteen years ago, the MAC clause was essentially an uncontroversial boilerplate provision, but the clause has since changed dramatically. This Note explores the modern MAC clause in the United States through a comparative analysis with the United Kingdom, which has effectively prohibited a transformation of the traditional MAC clause.
At the heart of the extensive literature on corporate-law federalism is the belief that federalism engenders regulatory competition and federalization eliminates it. Federalism, a mode of governance where states act as providers of corporate law, is said to drive states to compete for charters. By contrast, federalization, which occurs when the federal government promulgates law, preempts state-level competition. Consequently, scholars who believe that regulatory competition promotes the provision of “good” laws have long railed against federal securities statutes like Sarbanes-Oxley that nationalize elements of traditional (state) corporate law. Meanwhile, other scholars have lauded preemptive securities regulation, arguing that federal intervention prevents the dismantling of regulatory standards and a race to the bottom.
In January 2003, the Slammer worm hit the Internet. Five of the Internet’s thirteen root-name servers shut down. Three hundred thousand cable modems in Portugal went offline, all of South Korea’s cell phone and Internet services went down, and Continental Airlines cancelled flights from its Newark hub due to its inability to process tickets. It took only six months after the disclosure of a security flaw for a virus writer to write the 376 byte virus. When it unleashed, it took ten minutes to infect ninety percent of vulnerable systems.
The flaw was a buffer overflow in the Microsoft SQL Server 2000 software. Because the code is embedded in other Microsoft products, not all users were even aware that their systems were running a version of SQL Server. Unfortunately, this was a well-known, preventable security flaw. Moreover, Microsoft had released a patch for the flaw exploited by Slammer six months before the attack. Despite the widespread effects, no flood of lawsuits ensued.
Congress passed the Sherman Act in 1890 to combat the monopolies, trusts, and pooling arrangements that arose as businesses expanded in the wake of the Industrial Revolution. The purpose of the Act was to prohibit the price gouging effects that resulted from the cartel-like behavior of rapidly growing businesses, best represented by the controlling – and later, declared illegal – position of the Standard Oil Company. The nation resented growing corporations that “[s]eemingly at will…could raise prices to consumers, cut the wages of labor, favor some customers over others, and control the supply of basic commodities.” President Cleveland emphasized the need for legislation to protect average consumers stating, “Corporations, which should be the carefully restrained creatures of the law and the servants of the people, are fast becoming the people’s masters.” Legislators hoped that the Sherman Act would be a solution to these ills and that consumers, and later workers, would be protected from the power being amassed by corporations.
These Populist sentiments resonate over a hundred years later as activists, nongovernmental organizations (“NGOs”), and multinational corporations (“MNCs”) seek solutions to similar backlashes against the activities of behemoth companies. President Cleveland’s concerns are discernible as consumers demand greater accountability and protection from major corporations. The demands for reform, however, now come directly from consumers and NGOs, rather than legislators. Moreover, the sought after regulations to limit corporate excesses are being self-imposed in the wake of such pressure. The private sector is developing creative solutions to address the abuses that resulted from the rapid globalization of commerce and production.
Corporate law generally makes voting power proportional to economic ownership. This serves several goals. Economic ownership gives shareholders an incentive to exercise voting power well. The coupling of votes and shares makes possible the market for corporate control. The power of economic owners to elect directors is also a core basis for the legitimacy of managerial authority. Both theory and evidence generally support the importance of linking votes to economic interest. Yet the derivatives revolution and other capital markets developments now allow both outside investors and insiders to readily decouple economic ownership of shares from voting rights. This decoupling, which we call the “new vote buying,” has emerged as a worldwide issue in the past several years. It is largely hidden from public view and mostly untouched by current regulation.
The new millennium ushered in a parade of corporate scandals. The succession of scandals, which began with the collapse of Enron, revealed a deep-seated pattern of disregard for shareholders’ interests. In response to these events and the widespread public outcry that ensued, Congress examined corporate board structure and senior management and passed the Sarbanes-Oxley Act (“SOX”) in 2002 to try to remedy problems of accountability. Even after SOX was passed, corporate governance experts continued to study the role of a board of directors and how that role may be modified in order to prevent future scandals and to protect shareholders adequately. They have analyzed many aspects of the board, ranging from the size, to whether the chief executive officer (“CEO”) should be the chairman, to the importance of truly independent directors.
A corporate inversion is a paper transaction in which an American corporation reincorporates in a foreign nation without moving any of its operations to that country. The principle reason that a corporation will invert is to save money on taxes, in some cases as much as $60 million annually. Politicians, believing these companies are reincorporating in a foreign country to evade taxes, have introduced numerous bills to try to stop these companies from moving overseas. Senator John Kerry, the 2004 Democratic presidential nominee, stated that he plans to stop inversions within 500 days of his election to office. These corporations, however, have demonstrated that they will not give up these tax savings without a fight. Leucadia National Corp., a company that underwent an inversion in 2002, has hired a high-priced lobbying firm to block congressional efforts to stop inversions.
Securities markets are commonly assumed to spring forth at the intersection of an adequate supply of, and a healthy demand for, investment capital. In recent years, however, seemingly failed market transitions—the failure of new markets to emerge and of existing markets to evolve—have called this assumption into question. From the developed economies of Germany and Japan to the developing countries of central and eastern Europe, securities markets have exhibited some inability to take root. The failure of U.S. securities markets, and particularly the New York Stock Exchange, to make greater use of computerized trading, communications, and processing technologies, meanwhile, seems to suggest some market resistance to technological modernization. In light of this pattern, one must wonder: How are strong markets created and maintained, and what might be law’s role in this process?
This Article attempts to articulate a model for understanding the needs of efficient market transition and the resulting role of law in that process. Specifically, it suggests a “cueing” function for law in market transition. Grounded in largely ignored lessons of game theory and in the microeconomic analysis of so-called network effects, cueing theory identifies the coordination of market participants’ expectations as law’s central role in market transition. Building on recent legal literature on private regulation, social norms, and the expressive function of law, this theory suggests that in securities market transition—whether it be market creation in central and eastern Europe or market restructuring in the United States—law primarily serves to convene, encourage, inform, and facilitate.
The recent crisis in the wake of the Enron debacle has demonstrated the importance of enlisting gatekeepers – such as accountants, underwriters, and lawyers – to prevent corporate fraud. But while a consensus may exist over the basic need to expand liability to gatekeepers, little is known about the appropriate scope of such liability. Going beyond the capital-market context, this Article develops a framework to determine the scope of gatekeeper liability for client misconduct. Specifically, the Article analyzes the fundamental tradeoff between the potentially adverse impact of gatekeeper liability on relevant markets and the incentives such liability provides for gatekeepers to foil wrongdoing. Expanding the scope of their liability will make gatekeepers increase the price of their services to reflect their liability exposure. Although initially appealing as a means to screen out wrongdoers, this price increase may turn out to have adverse consequences when clients vary with respect to their wrongful intentions: Rather than screen out wrongdoers, gatekeeper liability may drive out only law-abiding clients. Enhanced liability, however, will also induce gatekeepers to monitor clients and prevent them from committing misconduct. The Article explores the policy implications of this analysis for determining which third parties should face gatekeeper liability, identifying the adequate scope of gatekeeper liability, and recognizing the shortcomings of gatekeeper liability as an instrument of social policy. The Article concludes by putting forward a tentative outline of the proper regime of gatekeeper liability for securities fraud.